Historical Perspective on the Mortgage Payoff Debate

For many years, common financial wisdom has encouraged homeowners to pay off their mortgages as soon as they can. What is not common knowledge is when and why …

For many years, common financial wisdom has encouraged homeowners to pay off their mortgages as soon as they can. What is not common knowledge is when and why this became the conventional wisdom.

Let’s take a giant leap backward to 1929 to better understand where the common “wisdom” of mortgage elimination started. That was the year the U.S. stock market had a historic drop in value, spawning the Great Depression. Understanding the circumstances that led to this economic crisis is critical to understanding how that incident still affects our thinking today.

The stock market of the late 1920s was not unlike the stock market of the late 1990s: rapidly increasing with no apparent end in sight. Both eras saw a major devaluation of stocks, but there were some important differences.

Back in the 1920s, investors could buy stock on large margins—as high as $10 of stock for every dollar invested. There were few regulations about disclosure and unsubstantiated claims, which further fueled the buying frenzy.

Once the market turned, the leverage that had enabled investors to buy like there was no tomorrow became the cause of their woes. Between 1929 and 1932, the stock market dropped from 381.17 to 41.22—a drop of 89.2 percent.

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As the market fell, the brokerage houses “called” the margins, which meant investors had to pay off the losses they incurred with cash. And where was the cash? In banks, of course. So, off to the banks the investors went—only the banks didn’t have the cash.

Banks only keep a small fraction of deposits on hand in cash; they lend out the majority of deposits to borrowers for home loans. Thus, these margin calls led to “runs” on many banks across the country. A run on a bank occurs when a large number of depositors, fearing that their bank is running out of money, try to withdraw their funds immediately.

When the banks needed to raise cash to pay their depositors and restore their customers’ faith, they went to their borrowers—the mortgage holders—and demanded that they pay their loans back in full. At that time, loans included a “due on demand” clause that didn’t require cause. No one was concerned about the clause because it made no sense for the banks to make a demand that could so obviously not be met.

Banks make money by loaning out money, not by foreclosing on borrowers. However, in the 1920s, banks panicked and put the due on demand clause to work. This action was largely responsible for widespread foreclosures, which in turn led to the current wisdom that paying off your mortgage is the best way to ensure economic safety.

Needless to say, many things have changed as a result of economic mishaps in the past. The Securities and Exchange Commission (SEC), which monitors how investments are marketed and limits margin buying, and the Federal Deposit Insurance Corporation (FDIC), which insures deposits of up to $100,000 per bank account, were both founded in the 1930s. In addition, the Social Security Act of 1935 provided unemployment and disability insurance and a pension plan for the elderly.

These programs came too late to keep the stock market from hitting bottom at 41 on July 8, 1932, down from a high of 341, set on Sept. 3, 1929, a level not reached again until 1954.

All of this led to the following financial strategy: Pay off your house and live off your company pensions and Social Security income.

This strategy worked well for the Depression generation and their offspring, which can be attributed to the way they lived:
• Most purchased their homes for less than $20,000;
• Most moved only once or twice;
• Most worked in the same job for 30 years; and
• Most avoided debt.

The average life expectancy during the Depression was less than 60 years. By 1970, the expectancy had risen to about 70 years. Given that traditional retirement age was 65 years old, the average individual had about five years of retirement to plan for—not too daunting a task.

But times have changed. Now the average life expectancy is 78 years. With tax write-offs, the high cost of living and the need for increased retirement fund growth, perhaps paying off the mortgage is not the investment priority it once was.

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