This is a guest post from Robert Brokamp of The Motley Fool. Robert is a Certified Financial Planner and the adviser for The Motley Fool's Rule Your Retirement service. He contributes one new article to Get Rich Slowly every two weeks.
Everyone's looking for safe investments these days. Unfortunately, there's a price for security: low returns. A five-year certificate of deposit at a major bank like Ally pays just 2.4% APY today, and a five-year Treasury yields barely 1.5%.
But one investment offers a higher return and has the added bonus of keeping your retirement expenses low: paying down your mortgage.
What's the “return” on that investment? At the high end, it's the rate on your mortgage — that's if you don't itemize and therefore don't deduct mortgage interest when you file your tax return. Because the majority of taxpayers don't itemize, and with the rates on most existing mortgages landing from 4.5% to 7%, the “return” on paying off the mortgage looks pretty good.
What's the return if you do deduct mortgage interest? Here's the simple rule of thumb: Turn your tax bracket into a decimal and subtract it from 1, then multiply that number by your mortgage rate. That may sound complicated, but it's not. For example, someone in the 25% tax bracket with a 6% mortgage rate would earn an after-tax return of 4.5%. Still not bad.
But there's a bonus benefit of paying off the mortgage before kissing off the boss: You'll have lower expenses in retirement, so you'll need less income. The less income you need in retirement, the fewer investments you have to sell and the less money you have to withdraw from tax-deferred accounts. This will keep your tax bill lower. It also could means that less of your Social Security benefit may be subject to taxes. So you're lowering your retirement expenses in all kinds of ways.
Weighing the Pros and Cons
So, should you send extra payments to your lender in order to pay off your mortgage earlier? First, let's consider the benefits:
- As always with paying off debt, reducing your mortgage is a guaranteed return. It's especially worth considering if you have a large amount of cash you're not comfortable investing in stocks and bonds.
- Paying off your mortgage means you'll have more equity in your house, which could lead to a bigger reverse mortgage (a way for the 62-and-older crowd to turn their home equity into lump-sum or lifetime income, if needed).
- If you're paying private mortgage insurance (PMI), the sooner you build up equity in your home, the sooner you can stop paying that approximately 0.5% of your mortgage each year (for many homeowners, that expense is not deductible).
- You'll have the peace of mind that comes from being mortgage-free. As financial journalist Jean Chatzky wrote, “I … know from research I've conducted over the years that having debt makes you unhappy. It makes you unable to sleep at night. It stresses you out. Particularly when your income is going down — i.e., for most people in retirement.”
On the other hand, some conditions do warrant keeping the mortgage for as long as possible:
- You can earn a higher return on your investments than your mortgage rate. Given how low current rates are, this hurdle doesn't seem that difficult — though you'll have to take some risk, because cash or a bond fund isn't going to do it.
- You receive a significant tax advantage. However, keep in mind that the true tax benefit is limited to the extent that your itemized deductions exceed the standard deduction, which in 2010 is $5,700 for single taxpayers and $11,400 for married taxpayers; those age 65 or older get an additional $1,400 (if single) or $1,100 (if married) deduction each. Also, mortgage payments progressively consist of more principal and less interest. Thus, the amount you can deduct declines each year. The bottom line: The mortgage-interest deduction can be valuable, but don't overestimate it.
- You value keeping your investments liquid (i.e., easily accessible), perhaps because of inconsistent or unreliable income, tenuous job security, or the peace of mind that comes from a fat bank account. Once you send a payment to the mortgage company, it's not easy to get it back. You'd need to take some form of home equity loan, which would take time and entail up-front and ongoing expenses.
Who Should Prepay?
The first financial priorities for most people should be to pay off credit-card and other consumer debt, build up an emergency fund, and max out tax-advantaged retirement accounts. But once you have those taken care of, paying off the mortgage early is worth considering.
Conservative investors and those close to retirement might even consider paying off the mortgage before contributing to an IRA or 401(k), as long as they're not passing up an employer match.
If you're younger, the math is more in favor of keeping the mortgage, since you'll be investing in long-term investments that have more potential to outperform the rate of your home loan. As you approach and enter retirement, your portfolio should become more conservative — which means that consistently earning 4.5% to 7.0% is not a sure thing, at least not at current interest rates.
We all want to be financially independent in retirement. Conceptually, debt is the complete opposite. It's not impossible to owe someone money and still retire. In fact, that's the case for most retirees. But if you're looking for a safe way to improve your retirement prospects, especially after you've maxed out retirement accounts, paying off your mortgage is a solid strategy.