I recently met with a client that had come into a pretty significant sum of money. The first thing she did, to the chagrin of her financial advisor, the bank, and some friends, was pay off her mortgage. Many people, banks included, suggest that you keep the mortgage because of the tax deduction. While you do get a tax deduction for mortgage interest, we’ll see below how much this deduction actually saves you. Truth be told, there is no 1 right answer to the question should I pay off my mortgage. A lot of different factors come into play, both financial and emotional, and not one is more important than the next:
- Peace of mind. The client that I referred to above wanted the peace of mind to know that she owned her home outright. Period. End of discussion. This was of utmost importance to her therefore, no matter what kind of return the professionals said they could get her in the market, she wanted nothing to do with that.
- Interest rate differential. If you are risk averse and keep your money in a savings account, you know that the interest rates paid by banks are abysmal with most, if not all, falling below 1%. That being said, you are guaranteed to be paying a higher interest rate than what you are receiving. In this situation and assuming that cash isn’t a problem, then by all means pay off the mortgage.
- Tax deduction. This is a partial continuation of #2 above since we’ll have to tax affect the interest you are paying. (Writer’s warning for the math phobic: Calculations to follow!). As tax accountants, the happiness of our clients typically falls on whether they owe vs. getting a refund and, if the latter, how much of a refund. Looking at the total picture, we need to know how much this mortgage interest tax deduction is really saving us. If you have total mortgage interest expense for the year of $10,000 and you are in the 25%, you will save $2,500 in taxes. Yes that’s a significant amount of taxes but you paid $10,000 to do so. Of course if I was a bank I’d want you to do this :-)When comparing what kind of return you can get on your investment in the market, you would have to compare that to the tax affected rate of your mortgage. Using a 4% mortgage rate and again, the 25% tax bracket, your tax affected rate is 3% (4% – (4% x 25%)). If you can earn anything over 3% in the stock market or the real estate market, you should keep your cash and only make the minimum amount possible.
Notice that I started with the emotional decision. If making that mortgage payment each month is an emotional burden, then you have your answer. If not and you look at it strictly from a financial perspective, then you need to weigh all of the factors. An option that combines all three factors is to make more aggressive payments. If your monthly payment is $2,500 then pay $3,000+ with the extra amount going to principal. This way you 1) will pay it off quicker, 2) will hold onto the majority of your cash enabling it to continue earning a return, and 3) still get a tax deduction (albeit not as much).