As the post-COVID economic boom cools, the US economy is on the brink of recession. This daunting prospect has many people looking for ways to shore up their finances ahead of a downturn. If you’re thinking of paying off your mortgage to prepare for a recession, think again.
Should you pay off your mortgage before a recession?
Most homeowners would be wise to stay the course by continuing to pay off the mortgage monthly rather than in a lump sum, says Greg McBride, chief financial analyst at Bankrate.
“In a recession, you want to preserve liquidity, not restrict it,” says McBride. “Paying off the mortgage limits your cash flow.”
A little explanation is in order. To seriously consider paying off a six-figure mortgage balance, you need a six-figure amount of cash — the “liquidity” McBride refers to.
So the question becomes: would you rather trade your cash cushion for no monthly mortgage payments and a paid-off home, or have a six-figure balance in the bank but still owe on your home?
For most homeowners, it makes more sense to keep the cash and continue to pay off the mortgage in monthly installments.
Good debt versus bad debt
Having cash on a home can seem risky, but keep in mind where mortgages rank in the debt hierarchy.
Certain debts clearly harm your personal finances. Having a credit card balance is an obvious example of a bad debt. In this case, you’re paying double-digit interest rates to finance meals, vacations, and electronics years after you charge them to the credit card. You need to pay off that debt as quickly as possible, in good times and bad.
Mortgage debt, on the other hand, is the most attractive form of consumer debt available. Interest rates on mortgages are low compared to other types of debt, and the time horizon of the loan matches the long-term nature of housing as an asset.
Plus, if you’ve taken out a loan or refinanced in the last two years, you’re probably getting a rate in the 3% range. If that’s the case, there’s even less urgency to pay off the mortgage, McBride says. After all, you’ve locked in an all-time low interest rate for decades to come.
For most consumers, the home loan should be the last thing you pay off, McBride says. Instead, pay off any higher-rate debt you have, such as credit card balances and car loans. Then use your excess cash to build your emergency savings and fund your tax-efficient retirement accounts.
Think about your fears
Although the word “recession” sounds scary, the term simply means that the economy is contracting. Even a small contraction in economic activity is considered a recession.
Also remember: most recessions are mild, short-lived and forgettable. For example, in the two decades following World War II, the booming US economy went through four recessions, but continued to grow at a breakneck pace overall.
After turbulent times in the 1970s and 1980s – the US economy experienced two contractions in each decade – recessions have become rather rare. The U.S. economy went into recession in 1990 and then again in 2001. While those downturns gave workers and investors pause, neither turned out to be the kind of calamity that deserves to repay the mortgage or ending a prudent financial plan. .
The worst post-war downturn was the Great Recession of 2008, and a 2022 recession is unlikely to approach the severity of this financial crisis.
Even if the economy crashes, what would you accomplish by paying off the mortgage? If you lose your job due to an economic downturn, it’s best to keep the mortgage open and use your bank balance not only to make monthly payments, but also to buy food and pay utility bills.
“Home equity won’t pay the bills; money in the bank will,” McBride says.
Also, if the worst-case scenario occurs and you lose your job, you will no longer be able to tap into the equity in your home. Lenders require stable and regular income for a cash refinance or home equity loan. Without income, the equity in your home is locked in until you sell it.
Homeowners should also be encouraged to know that politicians, regulators and lenders have provided generous support during the COVID recession. Most homeowners were allowed to skip mortgage payments for up to 18 months without penalties. While there’s no indication the next downturn will look like the coronavirus shutdown, borrowers can take comfort in knowing that if things get really bad, the feds could offer another escape route.
At the end of the line
As with any rule of thumb, there are outliers – those people in special circumstances who might consider paying off their home loan before the hard times hit.
One such group is made up of homeowners approaching both retirement and the end of their mortgage. If you owe a modest amount — $20,000 or $25,000, for example — and just want to get rid of your monthly payment, it might be a good idea to write a check for the remaining balance.
For most homeowners, however, the threat of a recession shouldn’t affect how you approach your mortgage.