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%.
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.