When deciding to pay off one’s mortgage I discuss three things with clients: risk tolerance, expected return, and your personal balance sheet.
The risk decision is really made up of three elements:
(1) risk capacity – Are you able to financially take on risk?
(2) risk perception – Do you or do you not view things as being risky? and
(3) risk tolerance – How do you feel about risk?
Someone who is young and has very few responsibilities may have a low perception of risk and is financially able to take risk. However, an individual with three kids nearing college plus a mortgage, while he may like taking on risk, is not in the position financially to do so.
The next question is, “Have you looked at the numbers?” I am an analytical person, so I like making decisions based on the numbers. If the cost of the mortgage is lower than what I think I can make on an investment, then I should invest rather than pay off the mortgage. However, we need to compare not only the expected return of the investment but also the expected loss. If the investment is significantly more prone to losing money, then maybe the expected returns should be reduced. Also DON’T look at historical returns, but rather the expected returns based on the current valuation, dividends, and earnings growth (this is another discussion entirely). From this you can choose to keep the mortgage, if it has a lower interest rate than the rate of return you can get on the investment.
The last item to consider is looking at one’s personal balance sheet. If you have the money and can pay off the mortgage, assuming you can keep enough in the bank for emergencies as they arise, then paying off the mortgage does not change your wealth. What it does do is strengthen your overall wealth standing. You are better prepared to deal with unexpected events without the debt.
In my previous article How to Decide whether to Pay Off a Mortgage, I discussed the emotional questions of paying off a mortgage. In my next article, I will provide you with examples of how to analyze.
To learn more about James Cornehlsen, view his Paladin Registry profile.
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