One of the most hotly debated topics in personal finance is whether you should be totally debt free or not. While some people are hell-bent on getting rid of any type of debt faster than a hot potato, others tout its advantages, particularly for mortgages.
In this post, I’ll cover five main advantages of having a mortgage and when to wait for one. You'll find out whether it's a good idea to pay off a mortgage ahead of schedule and how much debt you should have to maintain a healthy financial life.
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Should You Be Debt Free?
Debt is a complex topic because some experts insist that no amount of debt is acceptable—even a home mortgage. Others say that financing a home is okay, but borrowing for a car or making purchases on a credit card is a financial mistake. And another camp thinks that just about any type of debt is acceptable, as long as you can afford the payments.
My stance is that controlling your debt is an important part of being financially healthy, no matter your age or stage of life. The type and total amount of debt you can handle depends on your unique goals and the bigger picture of your financial life.
There’s no doubt that having no debt can feel liberating. In an ideal world, no one would need to borrow because we could afford anything. But as you know, paying cash for big-ticket items isn’t always possible. And in some cases, using debt can actually be a smarter financial move than spending your cash.
You might be thinking how can debt ever be good? Well, debt that creates wealth or the potential to earn more money is incredibly valuable. It might allow you to finance a home that rises in value, manage your cash flow, get an education, or even start your own business. An inexpensive loan that comes with money-saving tax breaks is a powerful financial tool.
On the flip side, expensive debt that’s used to purchase consumer goods or services that depreciate quickly (like cars and electronics) or have absolutely no value (like clothes, dining out, and vacations) cause you to lose wealth, instead of build it.
For instance, if you charge $1,000 on a credit card with 25% APR (annual percentage rate) and pay it off in three years, the total you’ll pay with interest is over $1,500. You probably purchased something that you didn’t really need—and also paid 50% more for it! Not a wise move.
So you can’t lump all debt together and reject it wholesale. Don’t get so obsessed about eliminating inexpensive debt that you lose sight of how it can help you create wealth. That’s like not seeing the forest for the trees.
In other words, put debt in its proper perspective. Your ultimate financial goal should be to create wealth, not to simply eliminate all debt.
See also: 8 Financial Truths That Can Change Your Life
Your ultimate financial goal should be to create wealth, not to simply eliminate all debt.
5 Advantages of Getting a Home Mortgage
As I previously mentioned, mortgages are the most beloved type of debt—even though they’re typically our largest financial commitment. So what gives?
Mortgages are considered “good” debt for some very good reasons. Here are 5 ways getting a home mortgage can improve your financial life over the short- and long-term.
Advantage #1: The Home Mortgage Interest Deduction Cuts Taxes
One of the biggest gifts Uncle Sam gives homeowners is the home mortgage interest tax deduction. It’s a huge incentive to make the leap from renting to buying real estate.
A tax deduction is an amount you can subtract from your taxable income. It saves money because it reduces the amount of income tax you have to pay. When you borrow money to buy, build, or remodel a home, you’re allowed to deduct the mortgage interest you pay each year.
Let’s say you buy a home for $250,000 with a $50,000 down payment and a $200,000 mortgage. If the loan is fixed for 30 years at a 4.5% interest rate, your payment for principal and interest would be just over $1,000 per month, or $12,000 a year. In the first year, the interest portion of your payments would total over $8,900.
If you claim the mortgage interest deduction, $8,900 of your income won’t be taxed. Depending on how much you earn and your tax rate, claiming the deduction could reduce what you owe or increase your tax refund by thousands of dollars.
You can deduct interest paid on your main home and a second home on mortgage balances up to $1 million (or $500,000 if you’re married and file taxes separately). Additionally, interest paid on up to $100,000 ($50,000 if married filing separately) of home equity loans or lines of credit is generally tax deductible.
The main requirements to claim the mortgage interest deduction are that:
your debt is secured by the property
you have an ownership interest in the home
you file taxes on Form 1040 and itemize deductions on Schedule A.
By the way, student loans are another type of debt with a built-in tax deduction. Depending on your income, you may be eligible to claim up to $2,500 of interest your pay for an education loan. But there is no interest deduction for interest paid on other types of debt, such as credit cards, car loans, or personal loans.
See also: 8 Pros and Cons of Using Personal Loans to Consolidate Credit Card Debt
Advantage #2: Mortgages Are Relatively Cheap
While it might seem like buying a home has become less affordable in some areas of the country, mortgage rates are still at historic lows.
While it might seem like buying a home has become less affordable in some areas of the country, mortgage rates are still at historic lows. The average 30-year fixed-rate mortgage cost about 10% in 1990, but today (2015) 4% rates are widely available.
Because the Federal Reserve has confidence in our strengthening economy, they just bumped up interest rates by 25 basis points or 0.025%. That’s the first rate increase we’ve seen in nearly a decade.
Even so, a mortgage is still the cheapest large loan you can get with a 30-year repayment term. One reason mortgage rates are low compared to other types of credit--such as personal loans and credit cards--is because you go through a strict approval process. Another is because you have to pledge your house as collateral, which means the lender can take it if you don’t pay as agreed.
And when you factor in the tax deductibility that I just mentioned, your rate gets even cheaper. For example, let’s say you have a 4% fixed-rate mortgage and your average tax rate is 30%. That reduces your after-tax mortgage rate to just 2.8%!
Having such a low net interest rate is why your mortgage should be the very last debt you tackle. Paying it off would be like getting a risk-free 2.8% after-tax return on an investment. However, you could put your cash in moderate investments and earn 5% after taxes so make an even bigger profit!
Having a mortgage allows you to invest more money and create more wealth than you otherwise would. So keep your low-interest debt and use your excess cash to make investments that exceed what you pay for the loan.
See also: When Not to Pay Off a Mortgage Early
Advantage #3: The Value of Your Property Should Rise
In addition to a mortgage being relatively inexpensive, it allows you to own an asset that can appreciate in value over time. And when it does, your real estate can be a major source of wealth.
However, some real estate prices may not rise. How much appreciation you see depends on factors like the economy, your location, local amenities (such as the school system, public transportation, and access to shopping), the condition of your property, and how desirable your neighborhood is.
Many markets see home values rise at the rate of 3% per year. If you buy a $300,000 home, it could be worth close to $550,000 in 20 years! You’ll have $250,000 in equity even if you have an interest-only mortgage with a principal balance that never goes down.
See also: Best Mortgage Company to Shop Your Home Loan
Advantage #4: Fixed Mortgages Fight Inflation
If you plan on putting down roots and staying in a home for the long run, getting a 30-year fixed-rate mortgage is wise. Your monthly payment will never go up—even though your income and the cost to rent a comparable home probably will over the next three decades.
I mentioned that the Fed recently raised rates. They’re likely to make a series of additional small interest rate hikes over the next few years, which will affect all variable-rate loans, lines of credit, and credit cards. So if you have an adjustable-rate mortgage (ARM) consider refinancing into a fixed-rate product so you stay safe from rising rates.
And if you already have a fixed-rate mortgage that’s at least 1% above the going market rates, consider refinancing quickly to a lower rate loan to save money before the cheaper loans disappear.
Here are some of the best places to shop for a new mortgage, a refinance, or a home improvement loan:
USAA
Quicken Loans
Lending Tree
Lending Club
SoFi
Advantage #5: Mortgages Improve Your Credit Score
In addition to building wealth, having a mortgage can help you build your credit score over time. Having different types of credit accounts—such as installment loans, credit cards, and lines of credit—is a factor, albeit a minor one, in calculating your credit.
The idea is that when you use a variety of credit, instead of just one type, you can demonstrate responsible use of different kinds of financial products, which makes you appear less risky. Dutifully paying a mortgage on time indicates that you can handle a large financial commitment responsibly.
When you apply for and get approved for a mortgage, there’s an immediate, slight ding to your credit for opening a new account. However, when you pay on time (a major factor in your scores) and add a new type of credit to your mix, the net effect should boost your credit within six months to a year. And if you refinance down the road when you have a better score, you can qualify for a lower interest rate.
See also: 5 Ways to Get a Loan With Bad Credit
Should You Keep Cash or Pay Off a Mortgage?
Once you send money to a lender to pay off a loan early, you can’t get it back if you fall on hard times or have unexpected expenses.
To sum up, there are some terrific advantages to having a mortgage. If you’re flush with cash and have more than enough investments to fund your retirement, then paying off your mortgage might be best for you.
Just don’t forget that once you send money to a lender to pay off a loan early, you can’t get it back if you fall on hard times or have unexpected expenses.
I heard a guy on a popular financial radio show telling the host that he was so happy to have cashed out his retirement accounts and investments to pay off his mortgage earlier in the year. But he reported that he had just lost his job and had no cash in the bank to buy groceries or to pay utilities, property taxes, home repairs, medical bills, or for any type of insurance.
That’s why you don’t pay off a mortgage unless you’re already wealthy. If you drain your resources to give them to a lender in the form of extra mortgage payments, you lose control.
Then the only way to get your money back is to qualify for a home equity line of credit (HELOC), which might offer a percentage of your equity only, or to sell your home. Instead, stay safe by keeping your cash liquid.
How Much Mortgage Debt Should You Have?
Even though there are so many advantages to having a mortgage, you should never get one that’s more than you can afford. Lenders have guidelines about how much debt borrowers should have. You should also be familiar with your budget and make sure you can handle the monthly payment, plus property taxes, insurance, and estimated annual home repairs.
The typical requirement is that your house payment can't exceed 28% to 30% of your monthly pretax income. And the total of all your debts, including the mortgage payment, generally shouldn’t add up to more than 36% to 40% of your gross income.
While borrowing lets you pursue your dream of homeownership, taking on a mortgage and maintaining a home is a huge commitment. If your job or family situation makes it likely that you won’t stay in a home for at least five years, I would rent instead.
You should only buy a home when you’re confident that it will appreciate in value, you have steady income, and you qualify for a competitive interest rate.
And numbers aside, if you’re convinced that being 100% debt free is the only way that you’ll feel secure or have peace of mind, then don’t ever get a mortgage. Save up until you can pay cash for a house or be a long-term renter.
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