One of the more frequent questions we hear as financial advisors is, “Should I pay off my mortgage early or keep making the minimum payment?” In most cases, paying down debt is an easy decision. When talking about credit cards and auto loans, which generally have high interest rates and little tax benefit, depending on the circumstances the best choice may be to pay these off immediately. But when it comes to deciding whether or not to pay off a mortgage (or any other financial decision for that matter), in the end you need to feel comfortable with the strategy you choose.
Paying the Minimum
There are a number of reasons it may make sense financially to hold a mortgage and resist the urge to pay off the debt. First off, the payment of mortgage interest can provide a tax deduction, in some cases 25% to 40% of the amount of the mortgage interest. That means already historically-low, 30-year mortgage interests of 4 to 4.5% can decrease to an effective rate of about 3%.
Second, those excess funds that would have otherwise been paid towards the mortgage can be used to build up an emergency fund. Better yet, if a solid emergency fund is already established, the excess funds can be invested into a well-diversified portfolio. The argument is that those funds may achieve higher long-term returns than a mortgage rate. It is a particularly attractive option if those excess payments were to be directed to a 401(k) plan, where there may be the potential benefit of tax-deferred growth and an employer match on contributions.
To cap it off, mortgage debt is based on its current dollar value. As income and the cost of goods rise in the future, the relative cost of debt may fall. The Federal Reserve over the past three years has implemented some unconventional monetary policy, injecting money into the economy and raising the potential for future inflation. Holding a low interest rate, 30-year fixed mortgage can provide a hedge against potential future inflation. If that inflation does in fact materialize, monthly mortgage payments could become considerably easier to afford.
Paying Off the Mortgage
The arguments for simply paying off debt are also well-reasoned. First and foremost, tomorrow is not guaranteed. Paying off debt today while funds are available can help avoid the obligation of making future payments when funds may not be as plentiful. In addition, the strategy noted above (of paying the minimum and investing the rest) involves unknown future market returns. Paying off a mortgage improves the odds of a return equal to the mortgage rate.
Second, many would argue that the purported tax benefits of deducting mortgage interest are overblown. Take a look at mortgage amortization schedules and what you may find is that the interest is likely front-loaded into the beginning years of a 30-year payment schedule. By the time most individuals are in a position to pay off their mortgage, the available interest to deduct is miniscule. And that interest may only be deductible if there are other sufficient itemized deductions to raise the amount above that of the standard deduction.
Another significant factor to consider is the area in which the mortgaged property lies, or more directly the size of the mortgage. For individuals residing in the Midwest with lower median home prices, the value of a tax deduction may not be nearly as large as it is for residents of San Francisco, where median home prices are generally much higher.
In the end, you must feel comfortable that you can repay the amount of debt you take on. It is often an emotional and personal decision, and not one that should be made merely by analyzing only the dollars and cents. No tax deduction or potential investment can provide you with the peace of mind that your mortgage is paid, or that your retirement years will not be spent worrying about next month’s bill.
