Rules of Thumb on Mortgage Debt

Most people carry some amount of debt, whether in the form of a student loan, a mortgage, or a car loan. We look at some simple rules of thumb on debt, evaluate mortgage debt, and discuss whether you should pay off a mortgage early.

Presented by: Kevin M. Curley, II, CFP®

Indeed, making large purchases using someone else’s money is often a smart financial move. Borrowing is convenient, allowing you to purchase big-ticket items with less out-of-pocket cash. And, with today’s attractive interest rates, it’s relatively low cost. But taking on any amount of debt comes with risk. A financial setback can reduce your ability to repay a loan, and any amount of debt may prevent you from taking advantage of other financial opportunities.

How Much Debt Can You Afford to Take On?

When analyzing your ability to carry debt, take a close look at your personal finances, focusing on the following factors:

Liquidity. If you suddenly lost your job, would you have enough cash at the ready to cover your current liabilities? It’s a good idea to maintain an emergency fund to cover three to six months’ worth of expenses. But don’t go overboard. Guard against keeping more than 120 percent of your six-month expense estimate in low-yielding investments. And don’t let more than 5 percent of your cash reserves sit in a non-interest-bearing checking account.

Current debt. Your total contractual monthly debt payments (i.e., the minimum required payments) should come to no more than 36 percent of your monthly gross income. Your consumer debt—credit card balances, automobile loans and leases, and debt related to other lifestyle purchases—should amount to less than 10 percent of your monthly gross income. If your consumer debt ratio is 20 percent or more, avoid taking on additional debt. 

Housing expenses. As a general rule, your monthly housing costs—including your mortgage or rent, home insurance, real estate taxes, association fees, and other required expenses—shouldn’t amount to more than 31 percent of your monthly gross income. If you’re shopping for a mortgage, keep in mind that lenders use their own formulas to calculate how much home you can afford based on your gross monthly income, your current housing expenses, and your other long-term debt, such as auto and student loans. For a mortgage insured by the Federal Housing Administration, your housing expenses and long-term debt should not exceed 43 percent of your monthly gross income.

Savings. Although the standard recommended savings rate is 10 percent of gross income, your guideline should depend on your age, goals, and stage of life. For example, you should save more as you age, and as retirement nears, you may need to ramp up your savings to 20 percent or 30 percent of your income. Direct deposits, automatic contributions to retirement accounts, and electronic transfers from checking accounts to savings accounts can help you make saving a habit.

Evaluating Mortgage Debt Options

If you’re in the market for a new home, the myriad of mortgage choices can be overwhelming. Fixed or variable interest rate? Fifteen- or thirty-year term? If it were merely a question of which mortgage provided the lowest long-term costs, the answer would be simple. In reality, the best mortgage for a particular household depends on how long the homeowner plans to stay in the house, the available down payment, the predictability of cash flow, and the borrower’s tolerance for fluctuating payments. 

How long will you be there? One rule of thumb is to choose a mortgage based on how long you plan to stay in the home. If you plan to stay 5 years or less, consider renting. If you plan to live in the house for 5 to 10 years and have a high tolerance for fluctuating payments, consider a variable-rate mortgage for a longer term, such as 30 years, to help keep the cost down. If the home is a long-term investment, choose a fixed-rate mortgage with a shorter term, such as 15 or 20 years.

Is a variable-rate mortgage worth the risk? Because the monthly payments are typically lower with variable-rate mortgages, they are generally the easiest to qualify for—and may enable you to purchase a more expensive home. Variable-rate mortgages also allow you to take advantage of falling interest rates without the cost of refinancing. But keep in mind that it’s generally not wise to take on a variable-rate mortgage simply because you qualify for one. Although these mortgages offer the lowest interest rate, they’re also the riskiest, as the monthly payment can increase to an amount that may prove difficult to meet. Selecting a shorter loan term, such as 15 years, can help lessen this risk.

Remember, when it comes to taking on debt, the loan amount you qualify for and the amount you can comfortably afford to repay may not be one and the same. Be sure to consider your special circumstances before taking on debt to buy a home or make another major purchase. 

Should You Pay Off Your Mortgage?

Paying down your mortgage faster—or paying it off in a lump sum—seems like a no-brainer. For most Americans, a mortgage represents both the highest monthly expense and the largest liability on a net-worth statement. Intuition tells us that debt is bad, and being out of debt is akin to increased financial security. 

While it’s true that you can save thousands of dollars in interest by paying off the loan early, the interest rates for fixed-rate mortgages are historically low, and your mortgage interest is tax deductible. Depending on your circumstances, there may be better ways to use that extra money to boost your short- and long-term financial security.

With that in mind, here are some questions to consider before you aggressively pay down—or pay off—your mortgage:

• Do you have higher interest or nondeductible debt? If so, it makes sense to pay that off before paying down your mortgage. Credit card debt in particular should be a priority, as it has very high interest rates, and the interest is not tax-deductible the way mortgage interest is.
• Are you already maximizing the employer match on your 401(k) and your annual contributions to IRAs? If not, you may want to prioritize this over paying down your mortgage. An employer match is essentially free money, and qualified retirement accounts grow tax deferred (or generally tax free for Roth IRAs). These are critical opportunities to boost your retirement savings, and because there are annual limits to how much you can contribute, money you don’t invest now is a lost
• How is your emergency fund? It is generally recommended that you keep between three and six months of household expenses set aside for emergencies. You’ll sleep better at night knowing you have liquid assets if you need them. If your emergency fund is light, it’s probably wise to build it up before reducing your mortgage debt.
• How is your health insurance coverage? Whether it’s life, medical, disability, or long-term care, your financial security could be undermined if you’re not properly insured. The type or amount of insurance that’s right for you comes down to your comfort in managing risk, but addressing potential shortfalls in coverage might be a higher priority than paying down your mortgage.
• Do you have children? If you have kids, putting extra money into a college savings plan now will allow you to maximize tax-deferred savings and growth. You could even be eligible for a state tax deduction for your contributions, depending on where you live and the plan you choose.

While paying down—or paying off—your mortgage early is a worthy goal, it is important to align it strategically with other goals and within the bigger picture of your long-term financial security. If you have questions, we are happy to assist you in planning for these important decisions.

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.

Kevin M. Curley, II is a financial advisor located at Global Wealth Advisors 100 Crescent Court, 7^th Floor, Dallas, TX 75201. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network^®, Member FINRA  / SIPC,  a Registered Investment Adviser. Financial planning services offered through Global Wealth Advisors are separate and unrelated to Commonwealth. He can be reached at (214) 613-6580 or at info@gwadvisors.net.

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