Should you pay off your mortgage?
Yes. The real question is when should you pay off your mortgage? We think there’s a logical order of events to maximize not only your balance sheet but also the utility of your money.
When researching this topic recently, we came across some misguided advice and even a few myths that we thought had long ago been dispelled. After an engaging twitter conversation with our friends at Dividend Diplomats, we decided it was nigh time to finish the article!
The Mortgage Interest Deduction Myth
Do not fall for the trap so prevalent on the internet that states you shouldn’t pay off your mortgage because of its tax benefits. The truth is that few people benefit from a mortgage interest deduction. In order to deduct mortgage interest, one must first itemize tax deductions. In most cases, the mortgage interest number is the highest itemized deduction. For a married couple, the annual housing loan interest, combined with all other itemized deductions, must exceed $12,400 before it becomes a factor in taxes. Because interest on a mortgage is usually the largest itemized deduction by a wide margin, it’s worthwhile to consider what kind of mortgage one must service in order to claim the deduction. At today’s rates of ~3%, the couple would require at least a $413,333 mortgage – no thank you!!!
Those that do benefit from the mortgage interest tax break often miscalculate the size of the deduction by forgetting to subtract the standard deduction that they decline by itemizing. Let’s say that our example couple is paying $6,000 in interest and has total itemized deductions of $15,000. Is their mortgage helping their tax bill? A little, but not to the tune of $6,000. Itemized $15,000 – Standard $12,400 = $2,600. That’s the number that matters for calculating your effective mortgage APR, because it represents the difference between itemizing with a mortgage and taking the standard deduction with no mortgage.
Chipping away at a mortgage
Good idea to send extra payments if you pay MIP
If you bought a house with less than a 20% down payment – a frequent approach for FHA and first-time borrowers – then you’re likely paying a monthly MIP, Mortgage Insurance Premium. Because this insurance benefits only your lender, it’s often wise to accelerate payments until you reach the 80% LTV threshold. Contact your lender to establish the exact # you need to hit to drop MIP, and then contact them again when you reach the goal. This burst of payoff is quickly accretive to your monthly cash-flow and a very good idea to pursue!
After you have < 80% LTV, slow your roll
Sending an extra payment to your mortgage servicer doesn’t help your cash flow one bit. You’ll still owe the same amount next month, even if you write a $10k check to obliterate a chunk of principal. A year later, if you lose your job, you still need to make that monthly payment. The bank doesn’t care that you paid $10k extra just a few quarters ago; it wants its monthly cash flow promptly! By paying off your mortgage in small chunks, you expose yourself to the risk of a cash crunch for little reward.
Instead of slowly hammering away at the balance, pool your mortgage payoff money and invest it conservatively. Between high yield credit union checking/savings, municipal tax free bonds, CD’s, and an occasional blue chip dividend stock, you should be able to keep pace with your mortgage APR. With a small risk appetite, you might even be able to eek ahead of your interest rate. When the balance of your mortgage payoff fund exceeds the outstanding balance of the loan, then write perhaps the biggest check of your life and eliminate the monthly expense in one fell swoop! You won’t ever have to make a mortgage payment again, and suddenly your monthly cash flow is awash in riches. In the meantime, if you come across that dreaded cash flow crunch, you’ll have an enormous emergency fund. It won’t feel great to draw down your mortgage payoff dollars, but at least you’ll be reallocating cash and not begging for the mercy of a bank.
When does it make sense to payoff a mortgage?
After you invest for retirement
Max out your tax-advantaged savings accounts before you even consider paying off a mortgage. No matter what tax bracket you’re in, if you have room in your annual 401(k), IRA, or HSA contribution limit, making the contribution will put you further ahead financially every single time.
Before you pay off equivalent-rate student loans
Student loan interest is deductible above the line, meaning you don’t need to itemize it. If your tax-adjusted interest rates are equal, it’s advisable to hold on the student loans longer than the mortgage.
Before you retire
A simple answer for prospective early retirees: pay off your mortgage right before you retire. The Dukes of Dollars are strong advocates of a low-bracket retirement, meaning that you require such little income that your tax brackets and therefore dividend and capital gain tax rates are near the bottom tier, perhaps even 0%. With a mortgage payment in your monthly budget, this low-bracket retirement becomes incredibly difficult if not impossible. By eliminating your largest monthly expense of housing, you can drastically reduce the amount of post-tax dollars that you need to spend on a regular basis.
When you can pay off the entire balance
Building a balance that can conquer a mortgage leads to an interesting question – should you invest it? Maybe not entirely in stocks, but you will want to keep up with inflation if not your actual APR. This isn’t play money, free for heedless speculation. CD’s and interest-laden checking accounts likely won’t be enough. And bond rates aren’t going to help much either, though this being taxable money in all likelihood, you should browse the tax-free municipal bond market. Stocks might have a role here if you have an aggressive risk profile and it will take you about 5+ years to reach the tipping point. If you choose to invest in equities, do so conservatively. Stick with blue chips, maybe utilities, something steady and reliable with a decent income component to help pad your balance. Stay far, far away from technology and financials!! Some names to consider here: PG, JNJ, NSRGY, DEO, HSY, CL, WMT – all big, steady, and sporting strong balance sheets. Plenty of income and very recession-resistant.
Strictly from a mathematic perspective, the pool >> invest >> payoff approach we advocate may not be the best choice. It depends on your investments, how much risk you take to keep pace with your debt, and your tax situation. But we approach this question from a practical standpoint. When you have $50k set aside for an eventual payoff, you can absorb a lot of life’s more brutal punches. A job loss, illness or death in the family a plane ride away, medical problems: these all become much easier with beaucoup bucks in the bank. You can’t get those back from Wells Fargo after they cash the check, even if your life is in turmoil. So keep them for yourself until you’re ready to deliver a knockout punch to your mortgage balance. You might just get a leg up on the situation if you invest wisely and get a little lucky when M&A giants start salivating over your Unilever shares.
Disclaimer: Long all equities mentioned either directly or through index funds.