Should You Not Pay Down Loans These Days?

BY Paul Solman  September 14, 2012 at 10:07 AM EDT

Money or Mortgage
Creative Commons image courtesy flickr user nikcname.

Paul Solman frequently answers questions from the NewsHour audience on business and economic news on his Making Sen$e page. Friday’s query is being posted today since it was bumped by the Democratic convention. It comes from a reader at Next Avenue. The NewsHour has partnered with Next Avenue, a new PBS website that offers articles, blogs and other critical information for adults over 50.

I’ve read that in light of our sluggish economy, Americans should hold onto as much of their money as possible because we’ll need more of it just to keep the lights on when the dollar takes a nosedive. The suggestion is that citizens
should not pay down mortgages or auto loans in order to preserve their cash. Do you agree? And if not, what do you suggest?
–Barbara Ratliff

Paul Solman: Goodness no, I don’t agree. Not in general; not in principle — though there are a few asterisks, which I’ll get to in a moment.

Look, the first thing to realize, when you’re taking on and maintaining a debt, is that it’s costing you money. That is, you’re paying an interest rate. And that interest rate is almost always going to be greater than the return you’re earning on the investments you’ve got, unless you take substantial risk or are very lucky or cheat.

NextAvenue

Yes, if the debt is a housing mortgage, you can deduct the interest from your taxes. But every time I’ve done the calculation for myself, I’ve decided I’d be better off paying down the mortgage than keeping it and investing the money. That’s because I have to pay taxes on investment returns.


By all means, take the first available opportunity to refinance your debts to get the lowest possible interest rate. But as a rule, don’t take on more debt just to keep cash on hand.

So then why, you might ask, would someone who can afford to pay down a mortgage sometimes continue to hold one? I can answer that, since it describes my own situation. Our family wouldn’t have enough cash on hand for emergencies — unless we withdrew money from our pension funds, a cumbersome and sometimes costly procedure. That’s the first of my asterisks: it makes sense to have some cushion for catastrophe.

The second asterisk: a mortgage can be an inflation hedge. Say you take out a 30-year mortgage next week at an interest rate of 3.5 percent. (For those of you worried about whether you’re too old for a long-term mortgage, this post and its follow-up should reassure you.)

Say the yearly payment is $10,000. Now let’s imagine that inflation spikes in the next decade — to seven percent a year, to make up a number. Your wages rise seven percent. Your investment returns rise by seven percent. But you’re still paying a mere 3.5 percent in interest. So if inflation were to spike, you would be ahead of the game.

But this is a gamble. If inflation drops instead, you will not make money, and will be compelled to refinance again.

To come clean once again, I took out a mortgage eight years ago on the basis of just such a “hedge,” locking in an interest rate at when then seemed a ridiculously low 4 7/8ths percent. It cost me money.

What do I suggest? That depends on your age, your assets, your financial needs, your risk tolerance. There’s no one-investment-fits-all approach. My own asset preference and allocation is here.

As usual, look for a second post early this afternoon. But please don’t blame us if events or technology make that impossible. Meanwhile, let it be known that this entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions