Your home is your largest and most expensive physical asset. Inevitably, you’ll have thoughts of retiring your mortgage early by paying a lump sum or by making extra payments. Let’s assume that you bought a $500,000 home with a down payment of $100,000, leaving you with a balance of $400,000 which you financed with a 30-year loan at a fixed interest rate of 6.0% per year. Ignoring property taxes and homeowners insurance, your monthly payment for the principal and interest is $2398.20. Over 30 years you will pay $400,000 in principal and $463,352 in interest, for a total of $863,352. Let’s also assume that you’ve paid down the mortgage over 20 years so that the principal balance is now $216,000 for the remaining 10 years. Assuming you have at least that amount in liquid investments, should you pay off the mortgage? Here are five reasons why you might want to keep it.
First ask yourself “Do I need to use the money right now?” If the answer is yes, then it’s foolish to pay off the mortgage. By paying off the mortgage, you’ve essentially sunk $216,000 into an illiquid asset. To access this money you can establish a home equity line of credit or home equity loan, both of which would then subject you to interest payments similar to the original mortgage. At worst you could sell your home, but the timing and amount of the payment are uncertain, especially in poor real estate markets. If you suffer a long term disability, have a family emergency, or have large medical bills to pay, the loss of liquidity from paying off the mortgage actually increases financial risk.
One great benefit of keeping the mortgage is the ability to deduct home mortgage interest annually on your tax return. Unlike other tax deductions and credits, there is no maximum income which specifically restricts your ability to deduct home mortgage interest as long as the loan does not exceed $1 million. In the first year of a $400,000 mortgage, approximately $24,000 out of the $29,000 goes to interest payments. Assuming the highest federal tax bracket (35%), you save almost $8500 in taxes in the first year, resulting in total after tax interest payments of $15,500 in the first year. Over 30 years, you save over $160,000 in taxes assuming current tax laws. Effectively this reduces the pre-tax interest rate of 6% to an after-tax interest rate of 3.9%. Where else can you find such a dirt cheap loan? Deducting home mortgage interest on your state income tax return further reduces tax liability. Therefore, by prepaying the mortgage you lose a substantial tax deduction.
Invest the difference
The tax deduction and the low after-tax interest rate allow you to leverage your investments. Borrowing money at 3.9% to achieve higher returns from other investments seems ridiculously easy. Assuming a 10% annual return in the US stock market, after the first year investing $216,000 should give you a return of $21,600 which exceeds the after tax interest of $15,500. In other words by paying $15,500 in interest you have almost a 40% return on the interest in the first year. After 10 years $216,000 grows to $560,000 assuming average stock market returns, whereas paying off the mortgage and investing the prior monthly payment results in over $60,000 less wealth in that time frame. At the same time you are also leveraging your home appreciation. If you achieve a modest 5% appreciation in your home’s value, in the first year your $500,000 home appreciates by $25,000, which again exceeds the after tax total interest payments. Similarly you achieve a 25% return on the original $100,000 down payment. Remember that your home appreciates regardless of mortgage payments. One recent study determined that keeping the mortgage and investing in a tax deferred account allows even greater leverage since both retirement account contributions and mortgage interest are tax deductible. Even if you don’t invest the money, it makes more sense to pay off other consumer loans, such as credit cards, which have much higher interest rates and which are not tax deductible.
Hedge against inflation
In 2007 the Consumer Price Index, which measures inflation, increased 4.1%, the largest rise in 17 years. Gasoline prices jumped almost 30%, energy costs soared over 17%, and food costs rose almost 5%, but what happened to your fixed rate mortgage? Absolutely nothing. By locking in the same interest rate for 30 years, your annual mortgage payments remain the same. In a sense the fixed rate mortgage provides a hedge against inflation since your housing costs do not rise with inflation. In fact the real rate (after inflation rate) of mortgage liability is actually negative. Similarly, keeping a mortgage cushions against a potential decline in the value of the house itself because you can use the borrowed money to invest in other assets which may appreciate faster than the house.
Finally, while it’s admirable to be debt-free by paying off the mortgage, you will sacrifice current consumption with future consumption. Becoming obsessed with paying off the mortgage can actually compromise your current lifestyle by reducing cash flow for current consumption. Similarly, you may actually increase the risk of failing to meet other large needs such as retirement funding or college funding.
In conclusion, keeping the mortgage has its advantages, but there are also compelling reasons why you should ditch the mortgage, a topic to be discussed in next month’s column.
Setu Mazumdar MD practices emergency medicine in Atlanta, GA and is a member of the National Association of Personal Financial Advisors (NAPFA).