Should You Pay Your Mortgage Off Early?
September 21, 2012A topic that comes up all the time in my conversations with people looking for guidance is the usefulness of paying off a mortgage vs. keeping it. This article talks about three homeowners who developed plans to pay off their mortgages in order to reach goals that are important to them. One wanted to have his mortgage paid off prior to retiring so that his cost of living in retirement was very manageable. It’s easier to retire comfortably if your biggest cash outflow item (for nearly everyone I talk to their mortgage or rent payment is by far their largest monthly obligation) disappears. Imagine how little you would need to live on if you didn’t have to pay rent or a mortgage! Another homeowner wanted to pay off the mortgage prior to their children going to college so that their monthly income could be used to fund education for the kids and the kids wouldn’t be saddled with massive student loan debt upon graduation. The last one wanted to aggressively pay additional principal on their mortgage in a bigger house while they had kids at home and after the kids were gone, they downsized and used the equity in the big house to fully pay for a much smaller, empty nest house. These homeowners all had goals and reached them.
They are all debt averse and paying off the mortgage was one of their biggest goals. But, is it the best financial decision? That’s a tough one to answer! There are a lot of different angles to consider when trying to determine if paying off the mortgage (either in small increments with additional principal payments or a lump sum from investment accounts) is something that works for you.
One of the angles is the tax deductibility of the mortgage interest. A lot of people that I’ve talked to tell me that their accountant has advised them to always have a mortgage in order to have the tax break. That advice is very common and a lot of people do exactly that.
But, here’s a different way to see that. In order to get the tax deduction, you have to pay mortgage interest to a lender. Let’s say that you pay $1,000/month in interest on your mortgage. That’s $12,000 for the year. (Yeah, you could’ve figured that out without my genius math skills helping out.) Let’s follow the money trail. You pay $12,000 and then get to deduct that from your income, which reduces your tax burden. If you’re in the 25% federal tax bracket, you see a net reduction in taxes of $3,000 by keeping your mortgage. If you asked me if I wanted to pay $3,o00 less in taxes, I’d absolutely say yes! That’s why accountants LOVE the mortgage interest deduction and recommend it so highly.
But wait…you paid $12,000 in interest to get that $3,000 deduction. Didn’t you just lose $9,000 in that deal? That’s a different view than most accountants have, but it’s one that merits thought. To me, it doesn’t make sense to pay $9,000 for a tax break!
A different way to consider the mortgage question is from an investment angle. Let’s say your mortgage is a 4% mortgage and as in the tax deductibility argument, you’re paying a 25% tax rate. That means your interest rate after the tax deductibility is considered is really 3%. So, the argument goes that if you think you can invest your money and earn more than 3% then you might be better off keeping the mortgage.
The question is can you do better than that? With memories of the 2008 stock market crash still fresh along with the “lost decade” of 2000-2010, where stocks were just about a break-even proposition, there’s no guarantee that you can beat 3%. By paying down your mortgage, you are getting a guaranteed 3% return (using the interest and tax rates in the example, your numbers will obviously be different) on your money. Over the long term, a well diversified portfolio should outperform 3% but there is no guarantee on that. This becomes a very personal decision for you but the investment argument makes more sense to me than the tax deductibility argument.
These are a couple of ways to view your mortgage that may help you determine if you’d like to pay it down faster than the stated payment plan. The best plan for you may be to pay it as stated, pay a bit more principal with each payment, or aggressively pay down your mortgage. I don’t know which is right for you and your family.
But, read this article about the thought process of homeowners who have paid down their mortgage to see if any of their reasons makes sense for you. If so, then you can begin to map out a plan to be mortgage-free. If not, maybe you can take advantage of today’s low interest rate environment to reduce your interest rate and raise the investment bar so that keeping your mortgage in place makes sound investment sense. This question keeps coming up in my conversations with people so I thought I’d give you a few different angles to consider. If you have other thoughts on this, that’s why we have a comments section below…