Everyone should be asking themselves at one point or another – “Should I Pay Off My Mortgages Early”?
When choosing whether to pay down debt or invest, the primary factors are the interest rate on the debt and what rate of return you think you could safely achieve by investing. Sometimes, however, this calculation isn’t as straightforward as it appears.
For example, even your after tax interest rate on a fixed-rate mortgage can change over time. Let me explain.
If your mortgage interest is your only itemized deduction (or if your other itemized deductions are not sufficient such that they’d be larger than the standard deduction), then only a portion of the mortgage interest deduction is really providing you with a tax benefit. Therefore, as the amount of interest you’re paying goes down–because your outstanding mortgage balance is decreasing–your after-tax interest rate increases.
How about an example or two?
Example 1 – Paying a $400k Mortgage Early?
Jim and Jane are married and have an average outstanding mortgage balance in 2009 of $400,000. Their mortgage has a fixed 6% interest rate. They’ll pay $24,000 in interest and receive an itemized deduction for that amount.
Jim and Jane have no other itemized deductions, so they only receive a benefit for the amount by which their mortgage interest exceeds their standard deduction ($24,000 – $10,900 = $13,100). If they’re in the 25% tax bracket, they’ll save $3,275 (or $13,100 x 0.25) in taxes due to their mortgage interest deduction.
Jim and Jane’s after-tax mortgage interest rate is 5.18%, calculated as follows: ($24,000 – $3,275) ÷ $400,000 = 5.18%
Example 2 – What About a $200k Mortgage?
Carlos and Carla are in the same exact situation as Jim and Jane–married, 25% tax bracket, 6% fixed-rate mortgage, no other itemized deductions. There’s just one difference: they’ve been paying their mortgage off for a longer period of time already, so their average outstanding mortgage balance in 2009 is only $200,000. As a result, they’ll pay $12,000 in interest this year.
Like Jim and Jane, Carlos and Carla only receive a tax benefit for the amount by which their mortgage interest exceeds their standard deduction ($12,000 – $10,900 = $1,100). If they’re in the 25% tax bracket, they’ll save $275 in taxes due to their mortgage interest deduction.
Carlos and Carla’s after-tax mortgage interest rate is 5.86% calculated as follows: ($12,000 – $275) ÷ $200,000 = 5.86%.
The Lesson
Each couple is in the 25% tax bracket and has a 6% fixed-rate mortgage, yet because they have different outstanding balances, their after-tax interest rates are different.
In short, if nothing else changes, your after-tax interest rate on your mortgage increases as you pay off the balance (unless you have other itemized deductions sufficient to surpass your standard deduction), thereby making mortgage prepayments relatively more attractive as time goes by.
Eventually, your mortgage interest will even be less than your standard deduction assuming you have no other itemized deductions. Once that happens, none of your interests are really tax deductible because you receive the standard deduction tax benefit regardless of the interests that you are paying, making it even more attractive to pay the mortgage off early.
About the Author: Mike Piper is the author of Investing Made Simple. He also blogs at The Oblivious Investor.
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{ 14 comments… read them below or add one }
@Mike – I like the discussion of the real after-tax mortgage interest rate. A couple of quick points on this are (1) unless you live in a state without an income tax, you will also be able to deduct your state income taxes paid which will push up your itemized deductions on 1040, and (2) for very high income earners, there is a phaseout of itemized deductions that works on a sliding scale (just Google ‘itemized deduction phase out [YEAR]“).
As a general rule when pursuing an early mortgage pay off strategy, one should also be sure they’ve taken care of:
1. Maintaining appropriate insurance coverage
2. Possess zero short-term consumer debt
3. Fully funding an emergency fund
4. Develop and update a retirement plan
5. Make contributions to tax advantaged retirement plans in (3)
If you’ve done all of that, paying off the mortgage is the next item up for bid.
Also, between the list above and the after-tax mortgage interest rates, finding investments that will return more than that over say 20 or 25 years shouldn’t be too difficult. However, if you’ve maxed out all of the tax advantaged retirement accounts, it can be difficult to get to those numbers because of taxes. So as Mike points out, it’s important to compare what you would get from investments on an after-tax basis.
“Unless you live in a state without an income tax, you will also be able to deduct your state income taxes paid which will push up your itemized deductions on 1040.”
Indeed. And many investors will have other itemized deductions like charitable contributions. I was just hoping to keep things a little bit simpler with the assumption of no other itemized deductions. (Assuming that non-HMI itemized deductions don’t exceed your standard deduction, the same “lower-balance-means-lower-after-tax-rate” phenomenon occurs.)
Since we are on the topic of adding complexity, readers should also note that there’s usually property taxes on a house, which will be tax deductible. This has the effect of pushing deductions up, and making the standard deduction factor less of an issue. This factor alone will in turn make paying off your mortgage early less attractive.
Also, as an mortgage ages and because of how amortization work, you are putting more towards the principal balance of the mortgage and less on interests. So the later the stage of the mortgage, the less of an effect paying off your mortgage will save you interests and thus taxes.
Ideally it would be nice if everyone would have large enough charitable contributions every year so that the mortgage interest deduction is second in size to the charitable contributions…
I don’t know too much about mortgages, but it seems like it’s advantageous to be in the higher tax bracket. So if someone were on the border of the 25% bracket, it would make sense to put money in a Roth IRA vs. a 401k, correct? That way they’d get those extra few percentage points (multiplied by the amount themortgage interest exceeds their standard deduction). I assume this is true of all interest, but is impractical because houses are likely our only purchases that have interest above the the standard deduction amount.
Hi Daniel.
I would still suggest basing your Roth vs. 401k decision on how you expect your current tax bracket to compare to your future tax bracket. That difference will have a bigger overall impact than the impact from having a lower after-tax rate on your mortgage.
As to whether this applies to all interest: Not exactly. A lot of interest (car loans, credit card debt, for example) isn’t deductible. And student loan interest, if deductible, is deductible regardless of whether you itemize or not.
Good point. I am a big proponent of Roth investments, but have friends who suggest that pre-tax investments are better due to the fact that they’ll be in a lower tax bracket. We all graduated college in the past few years and have starting working at entry level accounting and IT positions. I disagree with them since we are all going to be making much more money over the next 40 years. I’m the IT guy.
I’ve started looking at some of the tax forms, and I qualify for deductible student loan interest (fortunately? unfortunately?).
You already have the student loans (that’s a sunk cost). Finding out that you can deduct the taxes are definitely a fortunate event!
As to Roth, I would definitely contribute to that. If you are diligent in your contributions to your retirement vehicles, you will have a big enough nest egg where just withdrawing money from say a 401k/IRA would put you in a high income bracket 40 years down the road.
Good point, I guess perception makes a huge difference!
Pay off mortgages.
No investment pays like freedom from debt.
It’s worth mentioning that everyone is different and not all of us have the same risk profile. Some people (I would think you fall into this category) just simply sleep better at night not having any debt or any risky investments where other people can certainly handle a debt load if they are using that debt efficiently and either A) Arbitraging that debt by investing in something that pays a higher rate of return than the debt is costing them or B) Investing in an appreciable asset like a business, an education etc. Just food for thought because while freedom from debt is a good goal if you are a business owner then many times it is actually poor planning to not take on debt at times (i.e. if you can get acquire money via debt that costs you 15% but yet you can get an ROI on that same money of 30% with your business then not taking on debt is a bad decision). I am not really disagreeing with you though generally speaking because most people that would read my comment would totally miss the point and just think that I am giving them license to rack up a bunch of credit card debt so that they can buy a new big screen TV (which is the exact opposite of an appreciable asset or a cash flow producing asset
)
Hey Mike – Thanks for your examples.
Some things to note:
1) The higher your total income tax rate, the less one is inclined to pay off the mortgage.
2) You can only deduct interest up to $1million in mortgage indebtness. Hence, any big ballers out there want to limit their mortgage level up to $1million for tax efficiency reasons.
Sooner or later, you’ll pay off your mortgage if you keep working. You should aim for an amortization schedule to pay off all debt when you WANT to retire. If you don’t retire for another 20 years, then you’ve got 20 years to pay it off for example.
David, thanks so much for tweeting the $1K giveaway post the other day btw. Really appreciate it!
Best,
FS
Hi,
I gave mortgage for many years. Not as a broker, but as the person who actually granted the loan and administered it. This gave me a great insight to how mortgages work.
I frequently had customers who would ask if they should repay their mortgage or invest from the proceeds of a recent windfall. The safe thing was always to reduce your borrowing and then invest the later. That way, the world can go crazy but your house is always yours.
Do not let the tax cart get ahead of the safety horse, and do not underestimate the risks associated with investing.
Uhm, heck yeah, pay off the mortgage! That’s my vote. I don’t do ANYTHING, and I mean ANYTHING, just for a tax deduction. There’s got to be other factors at play. I’m w/Credit Card Chaser, if you want a tax deduction, find a charitable organization (or two or three) who’s mission lines up with your values and make donations to them. The tax effect is the same and charitable contributions, like mortgage interest, are still allowed if you’re hit with AMT – just thought I’d add my own flavor of complexity;-).