Should a Tax Deduction Keep You from Pre-Paying Your Mortgage?

As many of you know, I have a specific formula for buying a house that includes pre-paying your mortgage and becoming debt free in 7-10 years. It's not only my recommendation on what to do, it's what I've done in my life. And it's worked out pretty well for us.

One reason many people argue against pre-paying a mortgage is because you lose the deduction on your income tax return. Well, here's what Yahoo had to say about this issue:

Not everyone who owns a home can use the mortgage interest deduction, and where the mortgage interest expense doesn't do much more than replace the standard deduction, prepaying the mortgage only has a marginal impact on their taxes -- the margin being the difference between itemized deductions and the standard deduction.

Your goal to be mortgage-free isn't a nightmare. Keep the dream. I think that it's a great goal for homeowners to have the house paid off before they retire. What I counsel is to not abandon other financial goals, such as retirement savings, to focus solely on paying off the house.

My rule of thumb is, if you expect to earn more on your other investments, on an after-tax basis, than the effective (after-tax) rate on your mortgage, then don't prepay your mortgage. For example, if you're skipping out on contributing to a 401(k) plan and missing the company match, you should be contributing to the 401(k) up to the limit of the company match before making any additional principal payments on your mortgage.

This is in line with what I believe. If you can get GUARANTEED returns above what your mortgage costs you (such as matching funds from an employer 401k), you should put your money there first before paying off your mortgage. If, however, you simply take the money and invest it in the market and assume you can beat the cost of a mortgage, I'd go for paying off the debt. Not only is it a decent financial move, but being debt free gives you a feeling that money simply can't buy.

I'll admit that it's hard to argue with the logic of "I have a 5% mortgage and surely I can beat that in the market." From a purely theoretical standpoint, I think I would have the weaker argument. However, from a practical standpoint, I think I have the better argument. Why? Because while I've heard myriads of people saying they can take the money they would have used to pay off that 5% mortgage, put it into the market, and earn 5% or more back, I have never seen it done. Instead, what do the do with it? You guessed it -- they SPEND it. On TVs, boats, etc. -- items of pleasure, for sure, but not anything that improves their net worth. Not that everything they do has to improve their net worth. But when they make a financial decision based on one plan of action and do something totally different, then they are on shaky financial ground at best.

Hence I say -- pay off that mortgage!

For more thoughts on pre-paying your mortgage, see these links:

• Why You Should Pay Off Your Mortgage

• When to Pay Off Your Mortgage

• A New Way to Pay Off Your House

Comments

[Randy]

I was faced with this decision 7 years ago when my wife and I bought our first house. We opted to save and invest extra money (above and beyond our 401(k)s) instead of paying down the mortgage early.
The result is that our current net worth is enough money to pay off our mortgage three times over because of the significant returns we've seen over the 5.5% mortgage we have. I know that those returns are not guaranteed into the future and I know that we are rare in our dedication to saving (we have never bought a TV or a boat and only one car that was seven years old and still works great at fourteen years old).
These types of decisions are always very personal and need to reflect the individual, so please don't take my experience as a recommendation. I just want to point out that it can and has been done.

[S]

I have seen it done - my parents took the difference and invested it, and they are about to retire millionaires. I'm proud of them - they knew that the returns of the market would outweigh the financial benefits of prepaying the mortgage, and acted on it. It is a nice feeling to be debt free, but sometimes you have to look at it in a purely analytical way.
Love the site!

[AncientVoice]

I guess I don't understand. I don't care who you are, if you're in the 15% tax bracket, pay the bank $2,000 in interest to get a $300 savings in taxes??? Why not pay off the mortgage, donate $2,000 to your favorite charity each year to get the $300 savings in taxes?

[Phillip]

One thing to consider is that your mortgage interest decreases over the life of the loan. So when you are pre-paying, you are decreasing your cash flow (by paying extra on the mortgage) as well as decreasing your tax write-off.

You have to be pretty disciplined to do this, but this is what my wife and I do...

We have a 4.875% fixed mortgage for 15 years. We also have a saving account that pays 5.05%. Instead of paying extra on the mortgage, we put it into the savings account. Our goal is to have enough cash to pay the house off when we want. However, we still have the money in the bank if an emergency comes up. It is better for me to know I have the money in the bank so that if I loose my job I can take my time and find something that is right for me, instead of having to jump on the first thing I find because of a cash-flow problem.

[plonkee]

Just so I'm clear.

If I have a mortgage fixed for two years at 5.48% and a tax-free savings account at 5.71%, for those two years I should pay any extra into the savings account and not the mortgage. (I'm assuming no mortgage interest deduction is relevant here.)

The alternative is that I should pay extra on the mortgage because I might spend the money in the savings account but I can't get the money back out of the mortgage.

What do you think?

[FMF]

Yep, those are the issues being debated here.

[plonkee]

I think on balance, that I personally would prefer to have the extra cash in savings as I feel more secure with extra liquidity.

This is actually the position I'll be in once my house purchase completes, but I don't really expect this set of circumstances to come up very often.

[Lord]

It certainly worked for me. One does have to watch the real after tax rate on the deduction. If you can't deduct it or the deduction becomes too small, than go ahead and pay it off. Too many bandy about the amount of interest they save. Interest is just the time value of money, and if you aren't considering that, you have bigger problems than the amount of interest you are paying.

[MVD]

The problem is that too many people have an "Either/ Or" mentality. Why not consider that there are ways that you can do both?

That is, while maximizing contributions in a 401(k) and Roth IRA, plus after-tax investments, you can still pay off your mortgage early. In a 5-year period, I was able to pay off my mortgage in full. This is what I did:

> I didn't buy more house than I could truly afford -- and before buying, I also factored in the costs of property taxes, insurance, and maintenance. I paid 20% down to avoid PMI, and also chose the mortgage carefully -- a 30-year fixed rate was preferable to those teaser rates that would have increased at someone's whim.

> I avoided Car Payments by finding the most reliable used car that I could buy outright. The one during that time was 5 years old with low miles, which I drove for 10 years. This saved hundreds of dollars each month in payments towards interest, depreciation, insurance (by getting collision only), and a less-costly annual car tag (which costs twice as much for a new car).

> I redirected my monthly 'Car Payment Money' to a money-market account, also called an Emergency Fund or Cash Cushion. This paid ME monthly interest instead of paying some LENDER interest that's non-tax-deductible.

> Periodically (for me it was every 6 months)I moved amounts that exceeded the amount necessary to keep for potential Emergencies. I alternated between sending additional payments towards mortgage principal and to a brokerage account.

> Meanwhile, any bonuses or overtime was used to a) Increase 401(k) contributions, b) Extra payments towards the principal, c) Investments, d) Charitable contributions, etc.

> The stock market was awful during some of those years (2000 - 2002), so much of that allotted Car Payment money went into Tax-free Municipal bonds. And their interest income also bought more bonds. Eventually, enough bonds had been accumulated so that the income from them covered most of my living expenses.

> When it finally reached the point where most of the monthly mortgage payment was being applied to the principal (the last 12 to 15 months), I no longer paid extra on the principal, and instead applied all of the Car Payment Money towards savings and investments.

> After living there 5 years, the mortgage was paid in full, which was equivalent to a huge increase in salary. And instead of 25 more years of mortgage payments, I was free to invest that much more!!

> This worked so amazingly well for me that when it was time to replace my car, there was enough in the Emergency Fund to pay cash for a new one, with enough left over to cover 6 to 8 months' of living expenses, if needed.

> Through all of this, I learned how truly empowering a Car Payment can be, as long as you're not sending it to a lender.

[J.D. @ Get Rich Slowly]

Interesting. I've just read two other stories about people who have paid of homes quickly. I'm going to have to check out your method...

[Matt]

I really think your approach undervalues liquidity. Especially given the fact that in a few years refinancing and equity loans will be basically unobtainable, it's good to keep cash on hand.

If you spend the money on prepaying the mortgage, yes your net worth will go up...but you won't be able to get that money back if you need it for something. Even assuming you can sell the house, where would you live? You can't eat net worth, nor sleep in it, nor pay your doctor with it, nor capitalize your business with it. In the end, it's just a statistic. Liquidity is what you can do those things with.

Whereas if you save and invest the money, it'll be available to you if you need it.

Which is not to say that prepayment is always a bad idea. It just seems foolish to put it so close to the top of one's priority list.

[db]

The thing I find so attractive about having the mortgage paid in full, is that in the event of that emergency you need a lot LESS liquidity to get by.

Let's take this scenario: You're 40 years old and lose your job. You are unemployed for 7 months. Would you rather have to tap your big 401(k) or savings account to pay a hefty mortgage every month, or would you rather be able to stretch out your basic emergency fund and live relatively easily because you have no mortgage (and likewise if you end up selling the house, would you rather get the full selling price in your pocket or only that portion in your pocket which remains after the mortgage is paid off?

Here's another scenario: you are 40 years old, have a serious accident and are forced to go on permanent disability. Would you rather have to worry about the cost of maintaining a residence on fixed SSI income, or have a home you can live in free and clear?

Hmm....think hard.

DB