Why not pay off the mortgage early if you have the chance? After all, do you like debt hanging over your head?
But paying off the mortgage early — and being free and clear of your largest debt — might not give you the peace of mind you would expect. Indeed, your rush to payment could be a gross misuse of your money, leaving you with a false sense of financial security.
Here’s why it’s not smart to pay off the mortgage early:
1. Mortgages – A Cheap Source of Funds
Unlike the early 1980s when mortgage rates topped 18 percent, mortgage rates today are four, five or six percent, depending on your credit history. Compare that low percentage fixed rates and variable credit card rates of 13-17 percent.
So, if you decided instead to pay off all your credit card debt, you would receive a far more sizable return on your investment. Pay off credit card debt at 15 percent, your return is 15 percent. Pay off credit card debt at 18 percent, your return is 18 percent. These are far smarter moves than paying off your relatively low-rate mortgage.
2. Don’t Try and Save an Underwater Mortgage
You know the old saying, “Don’t throw good money after bad.” After the past recession, millions of Americans found they owed more on their mortgages than their houses were worth. To try to emerge from that situation by pouring more money into the house to increase your equity just isn’t smart. Rather, let a rebounding market make your house whole again, without the use or help of your money.
And were you to short sale your house, with the bank’s permission, in many “non-recourse” states you’re not obligated to repay the lender, regardless of how much you left the bank short.
3. Mortgages Give You Tax Advantages
Every year, Americans recover about $100 million from the IRS in the mortgage interest deductions filed on their tax returns. In other words, the government has been subsidizing your homey lifestyle. Why end that cozy relationship?
Every time there’s talk of a limiting or erasing the real estate tax deduction, there’s a popular uproar to preserve it. Those in the highest tax brackets, as well as those who have bought a home more recently (when the bulk of your mortgage payment goes toward paying off interest, not principal) realize the greatest tax advantages.
But even if you’re in the 25 percent tax bracket, your 6 percent mortgage could be as little as 4.5 percent if you itemize, and even less when you factor in state income taxes (your tax rate depends on the amount of interest you pay and the total of your other itemized deductions.)
4. Re-pay with Inflated Dollars
This is Econ 101. Whatever you borrow and have to pay back later is a good deal in the sense you’re paying back the money with a devalued currency. The $1, $100, or $100,000 that you agree to pay back in the future will not be worth as much as it is today. The money you’re agreeing to repay will be an inferior product. It’s like paying back in gold or silver plate instead of the real thing. The metals’ value has been eroded by inflation. Similarly, a dollar 25 years from now probably will be worth less than 50 cents in today’s money, given a 3.1 percent inflation rate.
So, if someone told you that you had to pay her back, but said you could make repayments with cheaper money, wouldn’t you take her up on it?
5. Advantage of not Paying off a Mortgage Early
First off, you would never decide to pay off the mortgage at the expense of a better investment proposition. And there are few better than your employer’s workplace matching program, or 401(k), which typically matches 50 percent of your contribution up to 6 percent of your pay. If you’re not contributing enough to at least get the full company match, you’re missing out on a 50 percent return on your money.
At the same time, those dollars you’re dropping into your 401(k) plan reduce your tax liability. Were you to pay off your mortgage instead, you would not only lose your mortgage interest tax deduction, but you would be paying more in taxes because you would not be sheltering any contributions in a retirement account. You’re losing two different ways!
As for how much your investments will return in a retirement investment account are anybody’s guess, but historical data over 20- to 30-year periods shows that an asset allocation mix of 60 percent stocks, 30 percent bonds, and 10 percent cash would yield an average of more than 8 percent, about double the rate of what mortgages are priced at today
The Federal Reserve is also in your corner when it comes to finding better investment vehicles for your money rather than seeing you choose to pay off your mortgage early. The Fed found that homeowners who pay off their mortgages early, rather than contribute more to their retirement accounts, blow more than $1.5 billion a year, or about $400 per household.
The same research revealed that at least 38 percent of those prepayers were “making the wrong choice.” Had they invested more in their retirement accounts instead of paying off their mortgages, they would have gotten back 11 to 17 cents more on the dollar.
Money not used to pay off the mortgage can also be targeted toward more immediate needs, such as building up an emergency fund equal to a minimum of three months’ expenses. If other people depend on you financially, you might also consider taking out life insurance or increasing the size of an existing policy.
Another use for that mortgage payoff money could be taking out long-term disability insurance, which fewer than 30 percent of all workers have, despite the fact that one in seven U.S. workers is disabled for five years or more before age 65.
6. A Mortgage Payoff Could Send Your Income Tax Rate Soaring
If you were to pull money out of a retirement account to pay off your mortgage early, that money you withdraw and apply to your mortgage would count as yearly income. But Social Security benefits are only tax-free up to certain income limits.
You have to pay tax on part of your benefits if you’re combined income (from wages, investments, tax-exempt interest and half of your Social Security benefits) exceeds these thresholds:
- $32,000 if you’re married and file a joint tax return (as most couples do)
- $25,000 if you’re single
Here’s the shocker: If your income is more than $44,000, up to 85 percent of your Social Security benefits is subject to income tax, putting you in the highest tax bracket in the country.
So, the last thing you would want to do is trigger a taxable event like that just because you want to pay off your mortgage early.
Free and clear versus smart and sensible
If the thought of being saddled with a large debt raises your blood pressure and gives you insomnia, paying off your mortgage early should bring you great comfort.
Just keep in mind that it won’t, however, bring you the same kind of comforting financial return.
Peter is a staff writer at MyBankTracker.com who covers banking, personal finance, investing and homeownership.