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There are some things that people don't consider when deciding to pay down their mortgage balance or not.
If you decide to pay the minimum on your home and invest the difference because you have a low rate on your mortgage and you think you can get a higher rate of return somewhere else, then it's possible that you end up stepping over dollars to reach for pennies.
These decisions are not always made in a vacuum. Let's say that rates decrease and it starts to look like it makes sense to refinance, but now because you haven't paid down you loan, you don't qualify for the best rate. If that rate would have saved you even .25% in your rate over the long run, it would have trumped whatever marginally better savings you got in the stock market, or investment of the day.
But if you've actually been saving the difference, you can use those savings to pay down the mortgage in one big chunk if it will help you out. Or if you don't need to, you still have a large amount of money ready to use for another purpose if something else comes up - medical emergencies, being out of work, car repairs, whatever. If you've been paying extra on the mortgage, you don't have that flexibility. Your money is locked into the house whether you need it there or not.
Whether or not to pay off mortgage (or make extra principal payment) is a personal decision and hence there is no correct answer.
It depends on many personal factors. First, I agree that you should first max out all the tax-deferred retirement savings such as 401k/IRA. If you have money left, should you make extra principal payment?
I think the simplest way to approach this question is to consider paying off mortgage as investing in a CD, where the term (=maturity) is equal to the expected length of your current mortgage.
For example, suppose you expect to live in your house for 5 years (or refinance in 5 years) and your current mortgage rate is 6%. Then making $10k principal payment has almost the same effect as investing $10k in a 6% 5-yr CD. (If you want to know tax implication, see the next paragraph.) In both cases, you can't touch $10k for 5 years but they are both earning (or saving) 6% interests. If you are willing to invest $$$ in 5-yr CD, I bet you won't find a CD with 6% rate. In this case, it's better to pay off mortgage. Of course, not all people can lock their money for 5 years. That's why it's a personal decision.
Some may wonder what about the tax implication? As I mentioned earlier (see post #8), the effective interest rate on mortgage is not APR*(1-marginal tax rate) because of standard deduction amount. Suppose you are in a 25% tax bracket, then the effective mortgage rate is higher than 4.5% (= 6% * 0.75). For simplicity, let's say it's 5%. Then you need to compare this 5% with the effective interest rate on CD. Since interest income is taxed at 25%, the equivalent interest rate on CD is roughly 6.67%. In sum, paying off 6% mortgage has the same effect as investing in 6.67% CD with the same maturity. FYI, the highest 5-yr CD rate is 3.50% according to bankrate.com.
Many ppl say it's better to invest $$$ in stocks than to pay off loan. This is true, only if you are risk tolerant. The effective rate of return of stock (assuming long term capital gain taxed at 15%) that is equivalent to this 6% mortgage is roughly 5.6% ( = 5% / (1-0.15) ). Historically, it's easy to beat 5.6% return. If you are confident that your stock investment will net 5.6% annual return for the next 5 years, then it's better to invest in stocks than to pay off mortgage. But if you are not sure, or not willing to take the risk, then paying off is the prudent decision.
To summarize, extra principal payment on 6% mortgage = investing in 6.67% long term CD. It's a good investment at the expense of flexibility. And remember to diversify.
Pay off the house. Then you will have more money to invest in retirement. Yeah, the financial analysis of the previous posters are correct--however, there is another factor to consider: Your psychological health. When you pay off your residence you end up with a sense of confidence that is better than any high I've ever had. Then, take as much as you can and sock it away for retirment. That's what I did. I retired at age 53. My retirment income is 120K a year and is indexed to inflation. My ability to save skyrocketed when I paid off my house. All of a sudden, I didn't need to "prove my self" to others with a fancy car or a fancy wristwatch. All of a sudden I realized that my long term happiness revolved around my relationships with people. All of a sudden I became focused on an early retirment...now, you are probably different in what you will do. But the sense of self confidence from paying off the homestead is worth as much to me psychologically as my college degrees.
Pay off the house. Then you will have more money to invest in retirement. Yeah, the financial analysis of the previous posters are correct--however, there is another factor to consider: Your psychological health. When you pay off your residence you end up with a sense of confidence that is better than any high I've ever had. Then, take as much as you can and sock it away for retirment. That's what I did. I retired at age 53. My retirment income is 120K a year and is indexed to inflation. My ability to save skyrocketed when I paid off my house. All of a sudden, I didn't need to "prove my self" to others with a fancy car or a fancy wristwatch. All of a sudden I realized that my long term happiness revolved around my relationships with people. All of a sudden I became focused on an early retirment...now, you are probably different in what you will do. But the sense of self confidence from paying off the homestead is worth as much to me psychologically as my college degrees.
Congratulations on your success. That's quite an achievement. Glad to hear that you are enjoying your early retirement.
I agree with this poster. Some ppl don't like the burden of having debt in their books. They simply can't sleep over it. If you are so, then the value of paying off can't be measurable. You will enjoy the financial freedom.
And the poster who said that the deduction is over-rated hit the nail on the head. To many people don't take into account that you get the standard deduction regardless, I did my brother's return last year, and even with the mortgage interest (they have a smaller starter type-home), him and his wife still didn't have enough to itemize, so in effect they benefitted -0- on their taxes.
We're in the same situation- 9 years to go on a 15 year fixed note for an average-sized for the area house, and about $1200/year in property taxes. Our home tax and interest amount is significantly less than standard deduction so we effectively get zero benefit from the mortgage interest deduction.
We don't pay ahead on the 15 year note, but figure that having the option of hitting our mid-40s with the option of having a paid off house is a nice part of the family financial plan.
Some may wonder what about the tax implication? As I mentioned earlier (see post #8), the effective interest rate on mortgage is not APR*(1-marginal tax rate) because of standard deduction amount. Suppose you are in a 25% tax bracket, then the effective mortgage rate is higher than 4.5% (= 6% * 0.75). For simplicity, let's say it's 5%. Then you need to compare this 5% with the effective interest rate on CD. Since interest income is taxed at 25%, the equivalent interest rate on CD is roughly 6.67%. In sum, paying off 6% mortgage has the same effect as investing in 6.67% CD with the same maturity. FYI, the highest 5-yr CD rate is 3.50% according to bankrate.com.
I need to correct myself.
This example assumes you are paying off your mortgage balance entirely. On the other hand, if you are making extra principal payment such as $10k and you still itemize deduction, then the marginal tax rate 25% should apply. The effective mortgage rate in this scenario will be 4.5%. The equivalent CD rate is 6.00% instead of 6.67%.
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Originally Posted by Hoot Owl
I understand the basic idea of paying off a mortgage: to get rid of a huge chunk of debt. But I never hear anyone talk about the income tax DISADVANTAGES of doing it.
It seems to me that you're just hurting yourself when it comes to taxes.
What am I missing?
If you are talking about throwing all of your available money at the mortgage every month until you have paid the house off, that hurts. Bad. But it feels great when you suddenly have all of the money you were throwing at the mortgage to yourself.
If you are talking about paying the house off in a lump, that really hurts. For a long time. It feels like cutting off your arm. It takes quite a while before you start to feel the benefit, but the benefit is no less real. The paranoia and uncertainty of not having a big wad of cash on-hand is overriding to the perception of the immediate benefit.
If you have to spend everything you have to pay off the house, that probably doesn't make sense, but being unburdened by the mortgage is almost always the superior course to remaining underneath it.
Also, a lot of state property laws will not allow anyone to come after your equity in a homestead in the event of bankruptcy or civil judgement. If you get sued you will be extremely happy to have thrown that huge chunk of money into the house and will look pretty smart, like Skilling and Lay smart.
Another factor to consider when you pay off the mortgage balance is insurance claim in case of fire/flood. If you pay off the mortgage, then you are on your own to get the money from the insurance company.
If you have mortgage instead, then mortgage company will try to get the money from the insurance company on behalf of you. Of course, the mortgage bank will not simply hand all the money to you. They may give you half upfront. Then you need to prove that you repaired the house before you can get the other half. This happened to my colleague.
Another factor to consider when you pay off the mortgage balance is insurance claim in case of fire/flood. If you pay off the mortgage, then you are on your own to get the money from the insurance company.
If you have mortgage instead, then mortgage company will try to get the money from the insurance company on behalf of you. Of course, the mortgage bank will not simply hand all the money to you. They may give you half upfront. Then you need to prove that you repaired the house before you can get the other half. This happened to my colleague.
It depends on the insurance company. Ours gave us a check (under 20K) that included the lenders name. They said we had to call our lender to see how to cash it. We just took it to the bank and deposited. They accepted it. Normally we would have followed the stated procedure but we were in a time crunch since the buyers were scheduled to close in less than 2 weeks.
I assume if the damage was larger (100K or more) they may have different rules.
Yeah, this is really very dependant on your personal situation.
For example, I have no kids and an inexpensive house. I never have enough write offs to benefit from mortgage interest.
For someone like me, there is absolutely no tax disadvantage to paying off my mortgage. Wish I could.
But for my parents, who are self employed, with a ton of tax writeoffs and a nice house, it is probably of some benefit to them to be able to write all that interest off every year.
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