Don't pay off your house

This is somewhat of a controversial statement and it is not for everyone but bear with me and I'll explain to you why.

Your home is probably your biggest source of equity. When you bought your home you probably put down 5, 10 or even 20% down. If it has been a few years since you bought it then appreciation has probably given you free additional equity. Furthermore If you have been diligent you have been sending extra payments to principal to pay if off sooner, very commendable. These three forces combined have probably pushed your loan balance to value to less than 60% (Ratio of what you owe vs. what the home is worth).

Intuitively you might think that the more you lower your loan balance, the more you contribute to principal and the more equity you have in your home the safer you will be financially. However, you would be wrong. The more equity you have in your home the more at risk you are financially.

How could this be? Shouldn't paying off your home be one of the most financially sound and rewarding goals you should have? Well yes and no. Very few people have the financial fortitude to pay off their house. If you can pull it off and you want to get rid of that mortgage you should but not the way you're doing it.

Let us examine the risk with an easy mathematical example. Let's say you purchased a house for $100,000 and you put 5% down or $5,000 so your loan balanace starts out at $95,000. After five years the house has appreciated and it is now valued at $135,000. Also assume that you diligently sent extra payments and your loan balance is now $80,000. At this point your equity is $135,000 - $80,000 = $55,000. Are you safer now than when you just bought it and you only had $5,000 in equity? I don't think so.

What you have in the $55,000 equity scenario is your capital at risk. At risk of what? Life events come to you unexpectedly and you might find yourself one day without a job or without means of generating income for a while. If you call the bank and say "Hey I've been making exta payments to the loan so could you apply that extra money to the next six months of payments because I'm in a bind?" they'll promptly and vehemently deny your request. Furthermore the bank will have a big incentive to foreclose on you because of the equity. If you had to negotiate payment terms with the bank which position would you rather be in: a) with $55,000 in equity or b) with $5,000 in equity? The bank is more likely to negotiate with you in position (b) because they stand to lose a lot money if they foreclose. If the bank forecloses on you in position (a) they'll come out ahead.

Here's a better alternative. Instead of sending extra payments to the bank save that extra money, build an emergency fund and invest it. If you ever have trouble making the payments then you can tap into your emergency fund and save your house and your hard earned equity. If you already have a lot of equity in your house you should refinance and pull out all the equity you can. Then you can take that extra cash out and create your own emergency fund. If you keep growing your emergency fund to the point of exceeding your loan balance then you can pay off your mortgage in one lump sum. Isn't this a better and safer alternative?

Hopefully I have convinced you that having equity in your home is actually a very risky proposition. Taking your equity out and investing it instead of spending it requires discipline but it is well worth the effort. Look for part II of this article to learn an even better reason to not have large equity in your house.