Is Money in the Bank Always the Smarter Bet?

Is Money in the Bank Always the Smarter Bet?

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Owning a home while holding cash in a savings account is like investing in a portfolio of both stocks and bonds: You’ll need to find the right balance.


Jo Craven McGinty

Here’s a personality test masquerading as a financial question:

Suppose you are a homeowner who has a substantial amount of money sitting in a traditional savings account. Should you use it to pay down your mortgage?

“The surprise here is that when deciding whether or not to use long-term savings to pay down your mortgage, you can simply compare the interest rates to one another,” said Andrew F. Siegel, a statistics and finance professor at the University of Washington Foster School of Business, in Seattle. “If your mortgage rate is bigger than your savings rate, then you should reasonably consider paying down the mortgage.”

That sounds sensible, especially with savings accounts currently earning around 1% in interest on average and mortgages costing around 4%.

But in real life, there’s more to the question.

It may make more sense to pay down credit-card debt or an automobile loan that carries a higher interest rate than a mortgage. Or it could be more advantageous, though riskier, to seek greater financial reward in the stock market.

“There’s really no cookie cutter answer,” said Erin Lantz, vice president of mortgages at Zillow, an online real estate marketplace. “On one hand, it can be attractive to pay off debt. Another way to think about it is to compare what you pay on your mortgage with other investment opportunities.”

Ms. Lantz suggested asking yourself the following questions.

How much cash do you want to have on hand in case of an emergency? Are you paying a higher interest rate on other debt than you are paying on your mortgage? And what is your appetite for risk?

“The question is closely related to the concept of portfolio choice,” said Pedram Nezafat, a professor of finance at Michigan State University.

The historical annual average return for the equity market, Dr. Nezafat said, has been about 9.5%, while the return for the bond market has been about 3.5%. These two asset classes have different risk profiles, and depending on risk tolerance and the investment horizon, investors will allocate different amounts to each class.

Likewise, a portfolio that contains both cash and a home is more diversified than one with only a home.

“It is true that the expected rate of return in the bond market is smaller than the one in the equity market, but you hold bonds because they are not as risky as equities,” Dr. Nezafat said. “You may want to hold on to your cash and not increase your ownership in the house because cash is more liquid.”

Homeowners also may weigh whether the benefit of deducting mortgage interest from federal income tax outweighs the benefit of paying down or paying off the debt with savings.

“The question is does the tax deduction fully make up for the loss,” Dr. Siegel said, referring to the difference between the interest paid on the mortgage and the interest earned on the savings. “The answer is no.”

If a homeowner has a marginal tax rate of 35%, the tax deduction essentially lowers a 4% mortgage interest rate to 2.6%—still higher than the average rate of return on a standard savings account, which will also be taxed.

Because financial decisions involve many moving parts, Dr. Siegel said it can be helpful to separate out the effects of each one.

In this case, to isolate the issue of the cost of mortgage interest versus the rate of return on savings, he uses this scenario:

The savings account and mortgage start with the same amount of money—say $200,000 each. Each has a fixed rate of interest, and the tax rate is constant. As the savings are used to pay down the mortgage, the two figures will be depleted at the same rate, and if the interest rates are the same, the taxes will be a wash.

If they aren’t the same, as is typically the case, using savings to pay down the mortgage may still be beneficial.

“In effect, you can think about any mortgage prepayment as being invested in an ordinary savings account earning your mortgage rate over the remaining life of your mortgage loan,” Dr. Siegel said—assuming a real estate bubble doesn’t lead to a market crash, as it did in 2008.

After you weigh the different options, the decision to pay down a mortgage, sit on savings or spend the money on something else may hinge on personality.

“Some people do not like to have debt because excessive debt has long been the reason for financial hardship and bankruptcy, and hence emotional stress,” Dr.Nezafat said. “So, if having a peace of mind is important to you, then you may want to pay off your mortgage early.”

But, he said, you may be giving up on better opportunities.


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