Rethinking The Early Mortgage Payoff
The borrow-at-a-low-interest-rate-and-invest-to-get-greater-returns mentality was so embedded in our belief system that there almost seemed to be a stigma attached to not carrying a mortgage balance forever. When Washington Post personal finance columnist Michelle Singletary wrote "The suggestion is that paying off your mortgage is akin to being a chump," her words resonated with me. Some financial experts indicated that the early mortgage payoff had merely a psychological benefit but no clear financial benefit or worse, a financial disadvantage.
I won't tell you what to do because personal financial circumstances vary, and vary greatly over the life of a 15-year or 30-year mortgage. But I'll tell you what some of these experts were thinking and what they forgot to mention when it comes to paying off the mortgage. There's not a right or wrong approach, just much to consider to the payoff, save, and/or invest dilemma.
The early mortgage payoff
What is an early mortgage payoff anyway? Most precisely, it is paying off a loan prior to its original term; that is, paying a 30-year loan in less than 30 years (perhaps 10 years or 25 years). To a certain extent, though, an early payoff has come to mean paying off in a reasonable time rather than refinancing (often at a higher balance than the original mortgage) to infinity.
Alternative uses of money
At the core of the early mortgage payoff question is: if you weren't using your money to pay off the mortgage, what would you be using the money for? Here are some alternative uses of extra cash:
- Pay off non-mortgage debt (if your interest rate is higher than your mortgage debt, there are clear financial benefits to paying off this debt first)
- Build an emergency fund (having an emergency fund gives you a financial cushion in case you lose your job or have large, unexpected expenses; rather than borrow to pay expenses, you can use this fund)
- Set aside money in a savings account for regular but not monthly expenses (having cash accessible for life insurance, auto insurance, or an annual vacation, etc. prevents you from borrowing or tapping into investments)
- Contribute to your 401(k), SEP-IRA, and/or traditional IRA (it’s a good idea to set aside money for retirement; using these vehicles, you can possibly earn an employer match, lower your taxable income, and avoid capital gains taxes on increases in investment value, which one day, presumably, you'll enjoy)
- Contribute to a 529 college savings plan (your investment will grow tax-free and you'll owe no taxes on withdrawals)
- Fund your Health Savings Account (you’ll lower your taxable income, enjoy tax-free growth, and have money set aside for medical expenses)
- Contribute to a Roth IRA or a Roth 401(k) (your investment will grow tax-free and you'll owe no taxes on withdrawals)
- Invest in the stock market
The argument for carrying a mortgage loan rather than paying off the mortgage is that, over the course of 30 years or so, you'll earn more by investing than you'll save in interest through an early payoff. Though I am still in (and will remain in) the market for the long haul, we now know that investing doesn't guarantee a 10% return over just any time horizon. (To see past performance of the S&P 500 for a given time frame, check out this calculator.) So, it might make more sense to invest all along (in good years and bad) over the course of a career rather than investing for shorter periods of time. To get the growth that long-term investing is supposed to yield, don't wait until the mortgage is paid to start investing.
On the other hand, there is a glitch (besides the obvious of non-guaranteed returns) in the borrow-low-and-invest-high scenario: taxes. I'll explain.
Pre-paying the mortgage vs. investing (and investing in tax-advantaged vs. taxable accounts)
Let’s say you have a 30-year fixed rate loan for $200,000 at 6.0% and you have an extra $1,000 that you want to either a) apply to your principal or b) invest. If you happen to be sitting at year 5 of your mortgage when you have this $1,000 bonus, then you could pre-pay the mortgage and save over $3,400 in interest and immediately increase the equity in your home by $1,000. But if you invested that same $1,000 and happened to get an average of 8% growth over the next 25 years, then you’d have an investment account worth about $6,800.
- If you had invested the money in a Roth account, you’d have a nice stash of money and never, if you meet all qualifying conditions, have to pay capital gains tax. Ditto for a contribution to a 529.
- If that $1,000 had allowed you to make or increase your contribution to your traditional 401(k) or traditional IRA, you would you have lowered your tax bill; when you withdraw the money, you'll pay ordinary income tax on distributions.
- If you were able to contribute to your HSA (Health Savings Account, for those who have high-deductible health insurance coverage), then you’d have reduced your tax liability and enjoyed tax-free growth on your money as long as you use the funds for qualified medical expenses.
But, if you happen to have already maxed out your contributions to retirement, college-savings, and HSAs, and set aside plenty in cash reserves, then you’ll likely put that $1,000 in a taxable account. Selling the investment will trigger capital gains tax, which lowers your after-tax return; for example, right now, depending on your tax bracket, the 8% return might yield about 6.8% after taxes. In a few years, after long-term capital gains taxes revert to older and higher rates (up to 20%), after-tax returns will be even lower. (See this calculator to determine after-tax returns). Higher returns are better but the risk required to get this spread may or may not be worth it; of course, it depends on your mortgage interest rate, tax bracket, investment growth, and risk tolerance.
I should mention that the tax situation can get complicated in retirement. Having to remove more money from your 401(k) or traditional IRA will mean higher taxes, not at generally more favorable capital gains rates but at higher ordinary income tax rates. And a higher income from investments might trigger taxation on other sources of income. See Why You Should Pay Off Your Mortgage from the Wall Street Journal by Jonathan Clements for more on these potential tax consequences.
Jonathan also mentions: "Carrying mortgage debt into retirement doesn't create just tax hassles. You also lose financial flexibility because you have this big fixed monthly cost. That can make for tough choices in down markets, as you try to figure out which investments to sell in order to make the monthly mortgage payment."
What about the interest deduction?
Prepayments reduce the amount of interest paid and accelerate the decline in interest payments, reducing the tax benefit associated with the mortgage interest deduction. But its value can be equated to the annual amount of interest paid less the standard deduction (rather than the absolute interest amount; items such as property taxes or charitable giving can also boost itemized deductions). If you've got a $500,000, 6% fixed-rate mortgage loan and are married/filing jointly, then your mortgage interest should be greater than the standard deduction until the 24th year of the loan; in the loan's tenth year, you'll have about $25,000 in interest payments that could help reduce your taxable income by nearly $5,000 (above and beyond the standard deduction).
If you've got a $200,000 loan with the same terms (and married/filing jointly), though, then you'll lose the interest advantage in the seventh year and reap annual tax benefits of less than $1,000 in earlier years.
What to do about the mortgage
It seems reasonable to pay off the mortgage at some point. Extra payments speed up the mortgage payoff but between now and payoff day, that money sitting in home equity doesn't do you much good. Nevertheless, what's right for one person, couple, or family -- depending on income levels, cash needs, financial discipline, retirement plans, aversion to debt, risk tolerance, and tax status -- might not make sense for another.
Please consult your tax advisor for information on taxes and note that I have referenced federal tax regulations and not state tax regulations. When I was researching this article, I realized one of the reasons tax consequences are not frequently discussed: there are so many variables to determining tax liability that it is difficult to capture the actual results without considering lots of details about an individual's income, not just for the current year but subsequent years PLUS tax laws are constantly being changed. My main point in regard to taxes is that they have an impact on returns and that impact should be considered when comparing mortgage interest rates (return on paying the mortgage) with investment returns.