Last month I discussed several reasons why you should keep making mortgage payments instead of paying off the mortgage early. These reasons include need for liquidity, large tax deductions, potential higher investment returns, hedge against inflation, and lifestyle issues. While those are enticing reasons to keep the mortgage, there are equally good reasons to pay off your mortgage.
The hypothetical example I used last month assumed a $400,000 loan which is financed with a 30-year fixed interest rate of 6%, resulting in a monthly payment of $2398.20. Over the life of the loan, you would pay $400,000 in principal and $463,352 in interest, for a total of $863,352. If the remaining principal balance over 10 years is now $216,000, should you pay off the mortgage?
YES, PAY OFF THE MORTGAGE.
The liquidity myth
While it’s true that paying off the mortgage may result in loss of liquidity, it is also true that regaining liquidity is not very difficult. Establishing a home equity line of credit (HELOC) and taking a home equity loan are relatively easy things to do. Similar to mortgage interest, interest on a home equity loan or HELOC can also be deducted on your tax return on loan amounts below $100,000. Second, while liquidity might be compromised, cash flow will significantly increase. Your monthly expenses will be cut by almost $2400, leaving you with almost $29,000 in extra cash flow per year, or nearly $290,000 for the remainder of the loan period.
The tax deduction myth
Give me $100 and I’ll return $35 back to you. Deal or no deal? Of course no one would accept this deal, but this is exactly what you are doing when you carry a mortgage and deduct mortgage interest on your tax return. You are allowed to deduct only the mortgage interest not the mortgage payments (which consists of both principal and interest). In the first year of the mortgage you pay almost $24,000 in interest, which saves you almost $8500 in federal income tax assuming a 35% tax bracket. Translation: you are paying $24,000 (interest) in order to receive $8500 (tax reduction) back. Would you ever purchase an investment with a guaranteed loss? Furthermore, as the years pass the amount of interest paid per year decreases. By the twentieth year you are paying about $13,000 in interest so that the corresponding tax deduction also progressively decreases. Finally, because mortgage interest is an itemized deduction, you can take a deduction only to the extent that your total itemized deductions exceed the standard deduction. Since most emergency physicians will have high adjusted gross incomes (over $159,950 in 2008), the IRS limits the amount of itemized deductions (and indirectly mortgage interest deduction) that you can take. The end result is that the mortgage interest tax deduction is an exaggeration.
The investment myth
One common reason to keep the mortgage is that you can borrow money at a relatively cheap interest rate in order to make investments which have higher returns. Most people compare the mortgage interest to stock market returns. Unfortunately, there is no guarantee that the stock market will provide higher returns than the mortgage interest even in the long run. For example, over a ten year period from 1998-2007 an S&P 500 mutual fund had a 5.8% annual return, which is less than the mortgage interest rate of 6%. Paying off the mortgage guarantees a 6% annual return whereas investing in the stock market only gives you a highly uncertain chance of making a higher return. Second, in investment terms, the mortgage really is a bond where you are the borrower paying interest back to a lender. Therefore, comparing the interest on a mortgage to stock market returns is invalid. Mortgage interest should appropriately be compared to safe bond investments, such as Treasury bills. Recently the interest rate on Treasury bills has been less than 3%, far less than the 6% loan, effectively guaranteeing a loss. Finally, there is nothing special about using financial leverage via mortgages. You can establish a margin account at a brokerage firm and borrow money to purchase stocks. If you use your mortgage to leverage investments, there is no reason not to leverage your cash as well. Unfortunately, with any type of leverage, you can potentially magnify investment losses.
Perhaps one of the greatest benefits of paying off the mortgage is the psychological income, a number which you cannot quantify. Relieving yourself of your largest debt reduces expenses and brings you closer to financial freedom. Borrowing from a well-known ad, keep the mortgage: make an extra $60,000. Pay off the mortgage: priceless.
Practical recommendations: What should I do?
Like many financial decisions there is no right answer to this question. It is better to keep the mortgage if: you need a lump sum for a large financial need, you are a disciplined long term investor, you have a high risk tolerance, you have many years until retirement, or if you have other loans with higher interest rates. In contrast it is better to pay off the mortgage if: you need more cash flow, you want a guaranteed return, you have a low risk tolerance, you are nearing retirement, or you value peace of mind.
Setu Mazumdar MD practices emergency medicine in Atlanta, GA and is a member of the National Association of Personal Financial Advisors (NAPFA).
Internal Revenue Service
Donna Dudney, Manferd Peterson, Thoman Zorn “Mortgage Debt: The Good News”, The Journal of Financial Planning, September 2004
Phil Storms, “Real Estate: Mortgage Options for Retirees”, The Journal of Financial Planning, November 2001
Joe Tomlinson, “Advising Investment Clients About Mortgage Debt”, The Journal of Financial Planning, June 2002
Niki Hermanson, “Should You Pay Off Your Mortgage or Not?”, FundAdvice, November 2007
Gene Amromin, Jennifer Huang, Clemens Sialm “The Tradeoff Between Mortgage Prepayments and Tax-Deferred Retirement Savings”, Federal Reserve Bank of Chicago Working Paper, March 2007