Why you shouldn’t keep a mortgage just for the tax deduction
I think this logic is misguided. Let me show you why.
The Standard Deduction
The 2009 standard deduction for married couples will be $11,400. That means in order to gain any benefit from tax deductions, your interest paid must exceed this number. In other words, you would have to pay $950 per month in mortgage interest (not principal) in order to see any tax benefit from your mortgage payment.
If you had a mortgage on a $200,000 house at 6.25%, you would be barely exceeding the standard deduction for the first few years, assuming the deduction never increases (which it usually does). After that, you would be better off taking the standard deduction assuming you receive no other deductions.
So, in reality, such a tax deduction would only be helpful in house purchases in which your mortgage is $200,000 or more. Anything else and it’s almost pointless.
J.D.’s note: As I usually do with articles like this, I asked my accountant for feedback. His response was: “This article seems accurate, but the author makes the assumption that an individual will only have mortgage interest to deduct when comparing to the standard deduction. Other items that are deductible include state income taxes, property taxes, and charitable donations.”
He also added: “You should not look at the tax savings as the reason to purchase a home. It is only one component, and a minor one at that.” Basically, he agrees with CJ.
A Poor Trade
If you do itemize deductions, you’re still paying more in interest than you’ll save on taxes. This is the second thing that people overlook.
If you are paying over $11,400 in interest, that does not mean that you are paying $11,400 less in taxes. It means that $11,400 of your income is not counted as taxable income.
Let’s say you’re in the 25% tax bracket. If you pay $20,000 in mortgage interest, it will save you $5,000 in taxes. $20,000 of your income does not count towards taxes. Effectively, you are paying $15,000 to get your tax deduction. This is not the most financially sound advice I’ve ever heard. If you take such advice, I’ve got a really good deal. I will pay you $33 in exchange for $100. That’s the same type of financial advice as someone telling you that keeping a mortgage is a good thing for tax reasons.
The Risk Factor
The final benefit to paying off your mortgage is that it reduces financial risk to yourself.
Keeping a mortgage payment (and especially a high mortgage payment) is risky. In the unfortunate circumstance that you lose your primary source of income, your largest “asset” can quickly turn into your largest liability. This is a big reason why so many people are facing foreclosure these days. They got into a mortgage payment they couldn’t afford (or could barely afford) and all of a sudden when a small hiccup comes up in life, they are living on the street. Emergency funds are important to help offset these risks, but to truly eliminate the risk, you should pay off your mortgage.
I’ve heard of people who took out mortgages on their homes during the housing bubble so that they could invest the money in stocks. They argued that you get the tax benefit and stocks appreciate quicker than a house. As we can see now, this is an unwise financial decision. Sure, you could make lots of money. You could also make lots of money by winning the lottery, but that doesn’t make it a wise retirement plan.
When it comes down to it, I would rather have the safety of knowing that if the economy crashed and I had to work at McDonald’s for the rest of my life, I could still survive just fine with my current lifestyle.
Final Thoughts
While I know there are a lot of variables and other tax deductions I didn’t cover here, I think it’s safe to say that the old notion that keeping a mortgage simply for its tax benefits is not the best advice you can get. When it comes down to it, get the financial advice of a professional regarding your individual situation but don’t simply take their word for it. Have them show you the numbers before you start throwing your money away. I’d argue that even if the numbers are close, the risk factor puts paying off the mortgage in a slightly better position than not.
I’d love to hear some comments or scenarios where keeping a mortgage is better than taking the standard deduction.
This article was written by CJ at WiseMoneyMatters.com. This post represents CJ’s viewpoints, which are not necessarily my viewpoints. (Although I, too, hope to pay off my mortgage early.)
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There are 108 comments to "Why you shouldn’t keep a mortgage just for the tax deduction".
You don’t pay your marginal tax rate on all of your income, do you? What am I missing?
I do agree with the main point in the article, paying a ton of interest just to save a little bit of tax is incredibly short-sighted and makes no financial sense. In any case, a mortgage should be evaluated on a big-picture basis, consider what else you could be doing with the money instead of paying off the mortgage early but don’t keep the mortgage just for the tax deduction.
I can think of a few reasons why having a mortgage is better. First, I think the interest deduction was created to increase home ownership. Therefore, when comparing rent to buying, $1400 in monthly rent is not as good at $1400 in a mortgage payment because of the interst deduction.
Secondly, right now interest rates are very low. If you have extra money, you can pay off your low-rate mortgage, say 10 years early or you can invest it for 10 years. Well, over 10 years’ time you should be able to beat your low-interst, tax deductible mortgage rate.
Third, paying off your mortgage early means you just tied a lot of money into your house, making that money very illiquid.
As an example, my parents bought a house in the early 70’s. The rates were low – about 6%. They had a 15-year mortgage. By the early 1980’s interest rates had soared to 12% or 15%. My parents were locking their money into CDs at those rates. Thankfully, they hadn’t paid off their mortgage because they were borrowing low and investing high.
Of course this scenario will not always happen but for people new to homes and savings, it’s hard for them to look long-term. What is true today regarding interest rates is not always going to be true.
I do agree, however, that there is something satisfying about owning your home free and clear and that paying off a mortgage early sometimes makes sense.
As JD’s note’s from his accountant pointed out, this article ignores the fact that there are other itemized deductions that would be added with the mortgage interest.
If you have $8,000 in itemized deductions before your mortgage interest, and then $11,000 in interest to add to it, all of a sudden you have almost $8,000 more than the standard deduction, which significantly alters the numbers you gave.
While I agree with some of your points, I think some key aspects are left out of the equation. I don’t think it’s as simple as “you should always pay off your mortgage as fast as possible”.
Like Eric said, the math is completely messed up in this post. The author assumes that you pay your highest tax bracket on 100% of your income, but that is not the case at all. Therefore, the cost of having a mortgage would be a lot more than he shows since the taxes without the mortgage would be lower.
I agree with the thesis of the article “do not keep your mortgage only for tax benefits”, but that being said, Michele makes a ton of great points about the downsides of tying up money in your house.
The one thing though is that investing in paying down your mortgage is much less risky than a lot of investments that could give you a higher return.
It appears to be an “American thing” to not want to pay down the mortgage asap. Admittedly most Canadian are just as bad as Americans about their finances in general but I’ve never heard of any kind of “I don’t want to pay down the mortgage” attitude here.
This was quite interesting – the risk analysis was excellent.
Unfortunately as Eric points out the math is wrong in the “tax bracket” section – the author has assumed the entire taxable income is taxable at the marginal rate.
Michele – the author isn’t saying that paying off the mortgage will be better financially every time – just that it will lower your overall risk.
This is one of the reasons I’m grateful to be living in Canada. Whenever I talk to people of my parent’s generation about the sub-prime crisis in the States, the first response is usually, “That won’t happen to us here because our mortgages aren’t tax-deductible.”
Whether it’s true that the crisis will pass us by or not, it does remove one level of complexity from our system. It also avoids the syndrome of “buy the biggest house you can afford” that seems to be all the rage in the States (or was, until the crisis hit).
We paid off our house 2 years ago (I had just turned 40, so we were relatively young when we achieved this). That was the last of our debt. I cannot express how nice it is not to have a mortgage payment, car payment, any kind of payment. The freedom!!! The lack of worry!!! Because of this financial freedom, we are one of the few not bothered or really affected by the economic downturn.
I also plan to pay my mortgage off as early as possible and completely agree that the tax deduction of the interest paid is a week reason to keep a mortgage payment.
In order to accelerate the payment of the balance, I plan to lump my mortgage into the debt snowball method ,after fully funding an emergency account and maxing out annual contributions to my retirement accounts. I also plan to use any windfalls to prepay the mortgage. After some calculations, I figured that I could probably pay it off in 15 years by ONLY using estimated tax returns and annual bonuses.
Enjoy the content, keep up the good work.
You should fire your accountant if he thinks those calculations are sound. That is not how marginal tax rates work.
I do agree with the premise of your post.
@ Julie,
Canadians think tax deductible mortgage interest is the reason for the sub-prime crises??
“Effectively, you are paying $15,000 to get your tax deduction. This is not the most financially sound advice I’ve ever heard. If you take such advice, I’ve got a really good deal. I will pay you $33 in exchange for $100.”
Why do people always trot this out? It’s so wrong. You’re paying $15000 to live in a house. The cost of the house is reduced by the tax deduction. It’s really simple! There’s no smoke and mirrors going on here.
Also, most people can figure out how to deduct at least half of the standard deduction through itemization. The deduction for state income tax alone — which applies in most states — will get you pretty far. Arguing as if your only itemized deduction will be mortgage interest is rather misleading.
Great article. The statement of ‘keep your mortgage for the tax benefits’ irks me to no end. It’s almost as bad as all the financial gurus out there touting the Roth as the end all to be all of retirement investing, when in fact it’s only good if you are planning on being in a higher tax bracket when you retire or if you are able to contribute the max each year, when really most people won’t be doing either.
Thanks for all the great info!!
Rachel
Holy Crap!!!! It’s about time someone put to paper what I’ve tried to say and just was never any good at it…
Mortgage Interest is a NON VALUE ADDED expense, in-and-of itself. Period. There is no inherent benefit to homeowners in having to pay mortgage interest. Period. The tax deduction in no way makes up for the cost of paying it. Period.
Yes, there are some slight mistakes in the math. However, they only serve to highlight the real issue. JD’s accountant is spot on: “You should not look at the tax savings as the reason to purchase a home. It is only one component, and a minor one at that.” Basically, the tax deductibility of interest should, inherently, be the last thing one considers in the decision to purchase a home.
Oh, and I’ll leave one more note. It is possible (for a LOT of people, not just special people) for interest to be, essentially, a non-issue in the purchase of a home. My wife and I are about to close on a 200K home at <1% fixed 30 years. Yes, it’s fixed. No, it’s not 1% above prime. No, it’s not a familial loan. It’s Long story that I can prove later (hopefully by the end of the month) once the statements are signed and ready.
I generally agree with the article. The tax savings can be an incentive for some .. but it’s only an incentive. During the last 3-4 years – peak bubble – I was of the few in my peers who insisted on no mortgage. Those who argued against me whipped out the tired argument of ROI of cash in hand vs cash in the house. This was true, many years ago, but not during the bubble, nor the tech bubble – and they were ignoring the now : getting a 4-5% return “right now” is difficult. After having been through two layoffs in the house, my key argument was ” the deed trumped all”. The house was mine, period, and assuming I kept up with taxes etc – there was zero chance of me losing it – and then I looked at my detractors and asked : how many months of unemployment can you sustain before foreclosure ? Before the lights are shut off ?
Safety is very hard won these days. Old assumptions about income, and career have long been proven just as fluid as other criteria we weigh when making financial decisions. However, IMHO, we keep regurgitating advice partialy created by people who had pensions and long term safety that we no longer have.
And … deep breath. Back to work 🙂
I didn’t do the match to see how accurate it was because frankly, I suck at math. But the post does hit on a very important point regardless.
For most lower and even moderate income families with a small mortgage, the tax break is really insignificant if you don’t have many other deductions. Most of these families aren’t going to be itemizing deductions anyway, so if their mortgage interest and property taxes aren’t going to put them over the standard deduction limit, the tax benefits of a mortgage are moot.
When we first bought our house I know that was the situation for my wife and I. We have a relatively inexpensive home and our first years worth of interest and taxes paid was hardly $9,000.
But fast forward three years and now even though we’re paying less in mortgage interest, we have many more deductions that add up to provide a pretty significant tax break overall. So the amount of benefit you receive will largely be determined by not just how much interest you pay, but your other deductions as well as J.D.’s accountant rightly pointed out.
As a few people have pointed out, there is a mistake with the marginal tax rate. I’m not an accountant so this post (as with every post I put on my site) is simply me learning personal finance and putting it on paper. I actually only learned about how the marginal tax brackets work a few days ago while listening to Dave Ramsey. Well after I had submitted the article.
Regardless of that, the concept is sound as J.D.’s accountant has confirmed. If you really want the extra tax deduction, I’d suggest donating the money to charity rather than to your bank. It would do a lot more good there.
This math seems completely wrong to me too. Page 80 of the 1040 instructions shows that the border between 33% and 35% taxes is at $357,700, not where there article states.
The IRS instructions on page 80 show that you multiply by your tax rate but then subtract off an amount based on your filing status.
For married / joint, plugging in the $357,701 into the IRS’ formula for computing tax yields: ($357,701 * .35) – $28,425 = $96,770.
Doing the same with $357,699 yields: ($357,699 * .33) – $21,271 = $96,769.
So falling into the higher tax bracket only increased the taxes owed by one dollar. I believe this is because only the amount above $357,700 is taxed at 35%.
Overall this reinforces the author’s point further, but seeing such inaccurate numbers makes me question the validity of the article.
How did your accountant not notice the obvious math error with the marginal tax rate and say the article “seems accurate”? If you really did show him the entire article and that was his reply, I would be shopping around for a new accountant!
Otherwise, I do completely agree that paying mortgage to save on your taxes is a net loss.
After seeing how my 403B and IRAs have performed over the last 20 years, I no longer buy the “better to invest” theory. If I must eat cat food in my retirement, I’d like it to be in my own home and not a cardboard box on the streetcorner.
#8) <1% fixed? I’ll believe it when I see it
JD.. Good article. I’ve heard that nonsense spouted over and over. Spending a buck to save 25 cents is NOT a good financial plan.
You can also increase the cost-basis on stocks by the amount paid in commission, right? You don’t see people running around saying you should pay as much in commissions as you can for the tax benefit when you sell!! Just doesn’t make sense.
You can also deduct expenses for professional services, like your accountant fees. I’m sure they’d LOVE for you to pay them as much as possible in order to get that deduction!
I think I made my point.
Those tax assumptions are wrong. I’d have to look it up in the Code for the exact numbers, but it isn’t 28% or 33% of your entire salary – you get taxed a fixed amount of money then a percentage of any amount over a certain amount of earnings.
I would say it also depends on your interest rate.
Current market conditions notwithstanding, if your rate is 10%, you’re not likely to do better in the market, and your money paid in to your mortgage will theoretically increase at 10% plus whatever your house value appreciates. Just like credit cards, at higher rates you get an automatic great return when you pay them off.
If however you purchased your house recently, your rate is more likely around 6% or even less. Your deduction probably makes it effectively more like 4 or 5%. That is cheap money, and you could likely do better investing the difference at the mythical 8% people claim the market will do over a long horizon.
Now of course the market isn’t guaranteed to give you that 8% even over the long term, but neither is the housing market guaranteed to ‘always go up’. If you found yourself underwater on your loan, it might well be cheaper to cut your loses and walk away.
Another thing to consider, is the amount of risk you are taking when investing your cash into a single asset (your house) is much greater than say, spreading it out over the market in an index fund. If you lose your job and deplete your emergency fund and for whatever reason are facing foreclosure (uncommon scenario these days, I know) you could very well lose your house (assuming you didn’t get it paid off just yet) and you might lose all that money you pumped into it.
I agree that it doesn’t make sense to pay interest just to keep your deduction, but I suspect there are reasons why it does make sense to keep a mortgage around. It depends of course on your personal situation.
“I’d love to hear some comments or scenarios where keeping a mortgage is better than taking the standard deduction.”
Because, paying off your mortgage with today’s dollars is more expensive than paying it off with tomorrow’s dollars.
In the U.S. a “typical” 30 year mortgage gives you the benefit of keeping a static mortgage payment for a significantly long period of time. With proper planning, and not buying into all the shenanigans which led to this sub-prime crisis, it is, in the long run, better to pay for something tomorrow with devalued money than it is to pay for it today.
This is just good business sense. Every good business attemps to a) collect money owed them as soon as possible, and b) defer payment to others as long as possible.
Why? They earn more on the money they have, and it costs them to pay it out too early.
The assumptions built into this argument, or course, are that:
a) You have a sensible and affordable mortgage
b) You are bought your house as a place to live, not a speculative investment
c) You plan on staying there for a significant portion of the mortgage period
d) You do plan on paying it off eventually
e) You have planned properly with respect to an emergency fund and proper insurance.
Once all those things are in place, it makes significantly more sense to wisely invest any extra money at the end of the month than it does to pay off your mortgage.
If you have a mortgage rate typical of the last few years, you’re paying less than 7%. If you have your emergency fund and insurance in place, you can easily invest money which will average significantly higher than 7% over a 30 year period.
The S&P alone has returned about 11% annually over long periods of time. Wisely selecting equity investments can easily outpace the S&P, of course, this requires more work than most people are interested in doing.
Over 30+ years, investing your extra, discretionary money into an S&P index fund will be far more lucrative than paying off your mortgage early at a mere 7% or less return. By paying off your mortgage early with today’s dollars robs you of the power of compounding. Paying your mortgage off over time allows you to take advantage of that power while making your mortgage payments with dollars of lesser value.
But, as J.D. always says, do what’s best for you. If if helps you sleep at night knowing you’ve paid off your mortgage early then do that. It’s clearly what’s best for you
Paul – who did as was asked, and presented an argument for keeping your mortgage payment 🙂
I always love reading the heated debates that take place in the comments when these types of articles are posted. To me, the essence of this article and the comments can be distilled into what JD called the tagline for his blog “Do what works for you.”
I was able to deduct my mortgage interest this year, and it was nice to do so. However, if I wanted to pay off my mortgage in the next 10 years or so, a mortgage deduction wouldn’t keep me from it. Let’s all do what makes us happy and works of us. The math doesn’t always matter.
Those tax if you don’t calculate , you’ll end up in negative cashflow
Reducing liquidity was mentioned, but I think the key point in that is that paying down your mortgage early doesn’t do anything to help your cash flow for a length of time. If I make a couple extra payments on a credit card or a student loan, my next monthly payment is reduced. This is good for my monthly cash flow (or for my overall debt repayment because more of my monthly payment goes to principle if I keep paying the increased amount). If I make a couple extra payments on my mortgage, I still owe the regular payment amount next month and for potentially many, many months in the future. You don’t see the results to the bottom line without a very large time investment, or a sale or refinance (both of which are difficult in this market).
another thing to think about:
if you tie up a lot of money in your house by trying to pay the mortgage early, you have reduced your liquidity (as someone above pointed out).
so what happens if your house burns down?
if you tied up a bunch of money in the house by paying the mortgage, you are stuck waiting for the insurance company to figure out how much they will pay you for the house, which could take some time. if you put your emergency fund into your mortgage payments, you are in trouble.
if you built up a nice emergency fund instead, then it affects you much less when the insurance company drags their feet.
Ok, so I was also going to point out the flaws in the math – not taking into account the way our graduated tax-bracket system works – but I see that several commenters already took care of that. If an accountant think that these numbers “seem accurate”… I would not want him doing my taxes!
As for the actual topic of the article, I agree that tax benefits should not be the ONLY reason to purchase a home and take on mortgage debt; however, if all other aspects of the decision suggest home ownership is right for you, then it’s nice to know that you get a nice break come tax time too!
I apologize for the error, folks. I’ve excised the offending section in the interest of accuracy.
While it’s true that my accountant should have caught this, I should have caught it too. Something was bugging me about the numbers in the post, which is why I passed it along to him to review. I’m not going to fire my accountant over this (not a chance!), but you’d better believe I’ll have something to razz him about for years to come. 🙂
Also, although this error gives me a twisted stomach, I’m not going to mope on it. Instead, we’re going to use this as a learning opportunity. Tomorrow’s topic? Marginal tax rates. Boring stuff, I know, but obviously something that at least two personal finance bloggers need to learn more about.
Having a mortgage is both a financial and emotional decision. The financial side is easy – calculate your after-tax cost of having the mortgage and compare it to the investment alternatives. ie If it costs you 4% after tax to have a mortgage and you can not earn 4% (in the long-run) you should pay off the debt.
The emotional side is different. My personal income started melting away in October of 2008 as a result I paid off my mortgage completely. It removes so much pressure that I don’t even care about the financial side……the pay off is huge.
I know it’s since been edited, but I think the tax bracket thing deserves an article of its own! I hear this same thing from people all the time, especially with regards to, “Oh, no, I’m right on the borderline, I have to make sure I don’t have any more income or I’ll pay way more in taxes” or, in situations just like this, trying to do silly things to get a tiny amount of extra deductions to come in at a lower bracket, and spending money they don’t need to spend to do it.
At this time of year, more articles on tax subjects would be timely anyhow, so maybe you’ve got a new subject here. 🙂
Sybbis wrote: I know it’s since been edited, but I think the tax bracket thing deserves an article of its own!
Tune in tomorrow! 🙂
I think it was mentioned some in the comments, but it is worth mentioning that the mortgage interest you talk about helps meet your standard deduction. Now, everything beyond that amount can be itemized (state sales tax, donations, property tax) which in the end saves you more money.
Thanks for the informative post! I recently approached our accountant with this same question; we are 37 and 43 with one elementary school-aged child and owe about 45K on a home that is worth about 360K. Our accountant, who is on the financially conservative side, agrees with CJ. Our mortgage interest is small enough that we take the standard deduction as it is, and in the current economy we feel that we’re better off paying down the 5.25% mortgage than investing in securities or CDs that are paying much less than 5.25%. In our case, paying off the mortgage will make us completely debt free, which is an emotional freedom that we’re really looking forward to. Our accountant’s only caveat was to maintain a home equity line of credit even when the mortgage is paid off (as long as this doesn’t involve an annual fee) so that we have immediate access to a large amount of cash in a dire emergency.
I have thought for a while that having a bigger house and/or not overpaying your mortgage for mortgage interest tax deduction reasons was a bad idea.
I agree that paying 3x the value of the house in interest over the life of the loan is crazy for a savings of 25% of that off in taxes.
Yes, you take the tax deductions when they are available but it’s no reason to prolong the payment schedule if you can pay it off early.
Most of us make far too little money yearly and in our lifetime to afford to pay for our homes 3x and yet the banks never really mention it that way in the sense of cumulative money paid over the life of the loan.
It is a significant amount of stability and flexibility to pay off your mortgage early and people who argue about investing that cash rather than paying down the loan are wrong also, since you will have $0 in rent payments after the loan is paid off and can make up any time you missed in investments with higher amounts invested later.
Good article and timely for us. We will have our house paid off in 2 years. I won’t miss the deduction one bit. We contriubute 7 to 9% to our church each year and we get more deductions from that than the house, especially since our mortgage is under $40,000 now.
J.D., here is an amusing (if a little harsh… but it is attacking the national press, who really should know better) blog post about misunderstandings in the press about marginal rates. Your guest blogger is not alone. 🙂
http://blogs.tnr.com/tnr/blogs/the_plank/archive/2009/03/03/wealthy-idiots-meet-idiot-reporter.aspx
Unfortunately this guest post also neglects to acknowledge opportunity costs. Yes, you can put, say, $100,000 towards your mortgage and that will save you, let’s say for round numbers, $5,000/year in interest. But if you don’t do that, you will have $100,000 that you can invest. You have to compare the $5,000/year you would save by paying down the mortgage to the earnings you would make by investing the money. It’s not like your choices with the $100,000 are either a) pay down the mortgage or b) light the money on fire.
So this line, “If you take such advice, I’ve got a really good deal. I will pay you $33 in exchange for $100. That’s the same type of financial advice as someone telling you that keeping a mortgage is a good thing for tax reasons,” is not really accurate. It’s more like, “I will loan you $2,000, and then when you pay me $100 in interest, I will give you $33 of that back.” That might actually be a pretty good deal for me, because I have the use of the $2,000 at the same time.
@Courtney makes a great point that paying down your mortgage early doesn’t help with cash flow until the mortgage is completely paid off. Your next monthly payment isn’t reduced at all.
Hence, I wonder if those fixed rate interest only mortgages are still around. They became very popular during the housing frenzy and were villified as contributing to the current crisis that we are in. However, they make perfect sense for anyone who truly understands them.
Not only can you lock in today’s low fixed rates, but you can also increase your cash flow as you pay down the mortgage principal. As principal is paid off, your interest only payments are reduced each month.
Also, for individuals with “chunky” income (i.e., large year-end bonuses and the like), you can use that income to pay down principal in big lump sums annually rather than with monthly contributions. This alleviates the need to tie up cash during the year. Also, as the principal balance is paid off in annual installments, you can increase your cash flow (through lower interest only payments) from year to year.
Does anyone know if these types of loans are still available?
I agree with Sybbis… Way too many of us do not understand the way our progressive tax-bracket system works. I’ve heard people say that their net pay actually went down after getting a raise because it bumped them into a higher tax bracket – which is totally impossible without some other factor(s) at play other than (federal) taxes!
I’m looking forward to the post tomorrow on this topic – even if many of the readers of this blog understand it already. Who knows? Maybe we can all learn something new! Good call, J.D., on admitting to the oversight!
I could be wrong since I haven’t been paying taxes that long, but it sounds like the mistaken math may be a product of how tax rates USED to be calculated. I remember stories about my uncle who would watch his overtime very closely at the end of the year because if he crossed a magic threshold he would actually lose money because he would skip into the next tax bracket.
As far as the biggest GOOD reason to have a mortgage:
*Liquidity (which has been pointed out). Right now I am itching to overpay my mortgage because we have some extra cash every month, but I’m setting it aside because right now having more savings in the bank has a higher emotional payoff than a lower mortgage balance. If I were a couple years from paying it off I might feel different, but unless I win the lottery I’m not likely to pay it off for a while, even with extra payments.
perhaps I’m hanging with a more thoughtful crowd, but no one has ever told me not to pay down my mortgage for the tax deduction. What I have always heard is to keep the effective rate in mind when comparing loans. After itemization the home loan at 5% is [for me] actually cheaper than an auto loan at 4.5%. And while things are crazy right now I think if we use today as a buy point I think I am likely to make better returns in the market (if it weren’t for the liquidity issue stated above). My home loan of 5.375% has an EFFECTIVE rate of ~4%. I expect within a couple years that CDs may come back to that rate of return.
Over time I will re-evaluate my assessment and my best bet may change. Absolutely it is a case of “Do what works for you.” Finances are more than numbers. So much of a decision like this is what helps you sleep at night, and taking into account what you think the future will bring. You can’t put every dollar to best use because, as has been pointed out, an emergency account has a very low rate of return but is a necessity to offset risk. I think of investing and paying off debt as completely different things. They are in the same sentence because you have limited dollars to split between them. Paying off debt is defensive spending and investing is offensive spending. They serve completely different functions. As such in the long run I will most likely do both: I will increase my mortgage payment, and I will invest more money. Defensively I want a rock solid foundation from which to raise my family, and offensively I want to be rich in the future, though I’ll get there slowly ;).
Finally, as was pointed out overpayment on a mortgage produces a closer payoff date, not a lower payment. HOWEVER if you have overpaid on your mortgage and you need some breathing room you can call your bank and ask them to reamortize your loan. They would extend your payoff date back to the original point and lower your payment accordingly. My mortgage holder will do this at any point if I have $5000 to put toward principal (another reason I’m saving rather than putting it straight to the loan). My previous lender would do it once gratis, and I have heard of others that will do so for a fee. This is a option most people don’t think of and can add some flexibility to a tight budget.
I’ve been paying ahead on my mortgage, and things would have to get pretty bad for me to be upside down, which is a really nice feeling right now. A house isn’t a terribly liquid asset, but a house you owe more on than you can get for it is very illiquid, and Not A Good Thing if you’re in a position where you lose your job and need to move for a new one.
@ Chris / #20:
Yeah, I was expecting that reaction. I promise I will share proof after everything closes. To be fair, I was a bit facetious (not about the interest rate but about the total interest I will pay). To make it short: 5% base line interest + no limits to interest rate buy down (1%:0.25%) + no limits to seller contribution to interest rate buy down + a little of my own savings (which actually is the same as me paying a bit of interest) = <1% fixed.
BTW – I love the corollary you drew to commissions.
PS – Here’s the numbers I’ve looked at (sans tax implications)
http://spreadsheets.google.com/pub?key=phagrIvxYwhKXC0TMPBNHHw
I can’t believe people actually buy into having a mortgage around for the tax deduction. I’ve heard this same thing said about student loans. “I shouldn’t pay off student loans early because I get a tax deduction.” Well the interest you pay is a stupid tax. When you don’t have a mortgage/student loan payment anymore, you get to keep all that money you used to pay in monthly payments, which is a heck of a lot more than the tax deductions!
@ Josh, post 10. I’m Canadian, I don’t think it was caused by that. I KNOW it was caused by the Federal Reserve (Central Banks) artificially lowering interest rates and inflating the money supply.
Anyways, since we live in Canada our mortgage interest is not tax deductible. Even if it was, it still doesn’t make sense. Like they said in the article, why pay someone $100 to get $33 back? (Or whatever the ratio, as long as you’re paying more to get less back, it doesn’t add up.)
I believe it’s been said many times before, but I’ll repeat to keep it alive. Before prepaying your mortgage, make sure that you properly save money in an Emergency Fund and any retirement vehicles first. If something comes up, you can either stop prepaying the mortgage or have money in the EF to help you out of your bind.
At 27, I still don’t own a home. I tend to skim over mortgage information on personal finance sites to get the gist, but don’t focus too much on the details yet because I don’t plan on buying a home until the housing market finishes collapsing in on itself. When the price of homes stabilizes, and then starts to slowly rise again, that’s when I’ll be looking to buy, and hopefully I’ll remember the basics of what I’ve read on sites like this over the last few years. But, for now, I’m not sweating all the details.
Actually related to today’s post — I’ve done the calculation and it looks like when you take the mortgage interest deduction and property tax and compare them to one another, they mostly cancel each other out (at least here in California). This makes life slightly easier, because it means that when you calculate a monthly mortgage payment based on a sale price it’s actually pretty close to what you’re really going to pay. You have to add property tax, but subtract the interest deduction, and it comes back around to being fairly close to where you started.
@ neal frankie- couldn’t have said it better myself. I hope in 8 yrs to have my mortgage pd off and when I’m 32 with no mortgage, I hope to have a lot of possibilities open to me! Thanks for the inspiration.
I should also note that I have all of my debts paid off except for the house and have $10,000 in my emergency fund.
You should never pay down your mortgage INSTEAD of an emergency fund, but if you had the option to pay off your mortgage it reduces your risk much more than even a 6 month emergency fund.
Paying down your mortgage also gives you a lot of play if you lose a job and drain your emergency fund as your mortgage will be significantly less than the value of your home. This would let you sell your home quickly without dealing with a short sale or other credit damaging options. Granted in this scenario, you would lose some money on your home, but you are already doing that by being unemployed so it’s a wash.
Paying down your mortgage simply reduces your risk rather than gambling that life is going to go well. Unfortunately hiccups occur in everyday life. There is no way around it. So you need to be prepared for it by reducing your risk for the worst case scenario. Hope for the best but prepare for the worst.
I think one important idea for folks to remember is that a home is NOT an investment. The first thing a home is is a place to sleep, eat, and raise a family (hopefully with some level of comfort).
A home requires lots of upkeep and hard work. Regardless of tax incentives, folks should consider what a home is before getting glossy eyed over tax deductions.
Vince from Scordo.com
@Josh — No, we don’t think that the crisis was caused by mortgages being tax-deductible. On the other hand, tax-deductible mortgages cause a certain mentality in America (along with other incentives) that cause people to want to get as big a house as they can afford with as big a mortgage as the banks will give them. Banks started lending more and more money (with extremely low trial interest rates) to people who really couldn’t afford their mortgages after the trial period. (ie: sub-prime mortgages, etc.) And we know what happened from there.
In other words: people want as big a mortgage as they can get (for tax-deduction reasons), and banks gave out mortgages larger than they could afford.
Yes, I’m oversimplifying. Of course it’s not that simple. But it’s one aspect of the crash that doesn’t exist in Canada. (Also, Canadian banks are more regulated than banks in the States, I believe.)
Although we itemize and have a ton of deductions, which is helpful for us when it comes to tax time, I wouldn’t keep a mortgage or use tax preferred money (i.e. a home equity loan to buy another house, buy a car or invest in the stock market) to get the tax benefit.
I agree, an article on tax rates would be helpful. I’m tired of the lazy news folks out there getting this issue wrong, wrong, wrong when they are talking about tax increases on the rich. Regardless of how you feel about the idea, I’m offended by the bad reporting. ABC.Com had a recent article about all these professionals that made more than $250,000 that were going to reduce their income to save on their taxes under Obama. The reporting was simply awful and completely wrong and it made me wonder about the math skills of the professions interviewed for the article.
@Carrie / #35
“People who argue about investing that cash rather than paying down the loan are wrong also, since you will have $0 in rent payments after the loan is paid off and can make up any time you missed in investments with higher amounts invested later.”
This is provably wrong.
First of all, the fact that you’d have $0 in rent payments is irrelevant, because that would be true regardless of whether you paid your mortgage off early, or on schedule. After 30 years, you’re in the same situation in both cases: rent-free. In your example, you’d simply have been enjoying rent-free living for longer. Ironically, as I’m about to demonstrate for you, a lifetime renter would end up with the most money of all!
Here are some numbers to consider. Say you have $4,000/month, and you want to spend it buying a house, investing it, or some combination of the two. You take out a $360,000 mortgage for 30 years at 4.5% fixed. Your monthly payment is $1,824.07. Say we follow your example and put our whole $4,000 against the mortgage each month, paying it off as fast as we can. You’d have your mortgage paid off after just 9 years and 2 months. Then you start investing that $4,000, and you earn 8% on it for the next 20 years and 10 months. You’d end up with $2.5 million, 30 years after you first opened the mortgage.
Now, say instead that you choose to just make the required monthly mortgage payment of $1,824.07, and invest the remaining $2,175.93 every month, earning the same 8% rate of return in our first example. It would take you the full 30 years to pay off the mortgage, and you’d pay almost $300,000 in interest (compared to just $80,000 in the first example). However, after 30 years, when you’re finally just as mortgage-and-rent-free as in the first example, you’d have $3.2 million in investments, instead of just $2.5 million. That’s $700,000 more!
So, as it turns out, you *can’t* “make up any time you missed.” That’s the magic of compound interest.
Finally, as I alluded to earlier, it’s worth looking at the situation for a perpetual renter. Say instead of taking out a $360,000 mortgage, a person rents an apartment. The monthly rent is half what the homeowner’s mortgage payment is. Of course, the homeowner’s monthly cost remains the same for the entire 30 years, while the renter’s goes up. Let’s assume the rent goes up at the rate of inflation (3.5%), adjusted monthly (he has a nasty landlord). This person has the same $4,000/month available to them. They pay their rent with it and invest the difference. Amusingly, after 30 years, the renter has the biggest retirement portfolio of all! He’d end up with $4 million! Of course, by then, his rent has risen to $2,600/month, and he still needs a place to live (thus will have to keep renting), but with more than $1.5 million *more* than our “smart” person who paid off their mortgage early, do you really think he cares? That $1.5 million difference, if it keeps earning 8% per year and rent keeps rising by 3.5% per year, would easily pay his rent for the rest of his life!
@ Julie,
That is still not really accurate. People in America didn’t just start buying as big a house as they could get to get the tax deduction.
And the few people who did do that are the ones who have extremely large incomes and needed the tax deductions more. The people with extremely large incomes aren’t the ones losing their houses right now (yes, there are exceptions to this, but for the most part the rich don’t go into foreclosure).
Tax deductible interest has almost nothing to do with the housing mess America is currently in.
Kevin,
Your scenarios are perfect world scenarios. We don’t live in a perfect world. This guy might get laid off. He might increase his income. He might have to move to a new city where rent is twice as much. He might get hit by a car and be paralyzed for the rest of his life thus have to live on disability.
What does this person do if any of these things happen because the likelihood of something like these things happening is extremely high.
Your math is great and all, but it doesn’t take into consideration any variables. The best plan is to develop an adequate emergency fund to mitigate any short term risk. Then to pay off the mortgage ASAP to mitigate almost all risk completely. With a paid off house, you can work for Wal-Mart and pay the bills if you need to.
So why would you invest instead of paying down your mortgage if the stock market will give you better returns? You can answer that question by asking another: Would you take out the maximum possible mortgage on a house in order to invest? Lots of people did that last year and now are facing foreclosure and a loss on their investments. It’s not a smart move.
The only smart reason to invest instead of paying down your mortgage is the liquidity of investments. You can cash them in quickly to be used as an extended emergency fund.
@ Kevin #52
This is interesting stuff, thanks. There seems to be a problem with the rental calculation however. At least where I live, a person renting an apartment for $912 per month has a vastly less enjoyable home than someone who owns a $360,000 house. I know the rental payments accelerate to somewhat account for this, but it really is not a surprise that the renter ends up with more money.
It may be a little off topic, but no one has mentioned the stimulus plan’s $8000 tax credit for first time home buyers. Falling into this category, I’m looking for some advice. My situation is that I’m currently paying $550/month in school loan repayment with about 7 years left, and $330/month on a car loan with just over 2 years left. I net around $1400/month (after retirement contributions and all other deductions) from a solid engineering job for my state’s gov’t.
I’m seriously considering buying a house for myself and renting out 2 of the rooms for the first 2 years. I’ve been preapproved for a $120k loan and have received a pricing scenario of just over $1000/month including taxes, PMI, etc. Take note that I’m not talking about San Fransisco here. $120k could buy a decent/moderate 3 bedroom home in my Midwestern town of 50,000 people.
Considering that that $8000 credit would pay off my auto loan, I’m hoping for opinions on whether I’m getting in over my head. Should I pay down loans before buying the house? Or should I take advantage of this opportunity?
Just a note, paying DOWN your mortgage does NOT reduce your risk. Paying OFF your mortgage does. There is a difference.
The calculations are still wrong.
“Let’s say you’re in the 25% tax bracket. If you pay $20,000 in mortgage interest, it will save you $5,000 in taxes. $20,000 of your income does not count towards taxes.”
Actually, if you pay $20k in interest, roughly $8.6K can be deducted from income (you get the other 11.4 anyway). 25% of that is $2.15K in savings – which cost you $20K up front. It’s an even worse deal that he outlines. To get the $5K lesser taxes, he’d have to pay $31.4K in interest alone (assuming we only have a mortgage to worry about and no other itemizing deductions – a safe assumption, since so few people actually itemize anymore, despite the so-called benefits).
Not to mention that getting a huge house with that high interest also means you probably have a huge property tax pmt as well. Sure, you get to count it off if you itemize, but your property tax is now also partially a non-itemizing deduction: http://turbotax.intuit.com/support/kb/tax-content/tax-tips/6395.html. In saner parts of the country, that’s enough to offset what you pay. Not to mention you are $20K ahead of the guy in the example, not counting his property tax payment.
“If you are paying over $11,400 in interest, that does not mean that you are paying $11,400 less in taxes. It means that $11,400 of your income is not counted as taxable income.” – Actually, this should read that “the interest you pay over $11,400 is not counted as taxable income.”
And for those that do have huge mortgages and local/state taxes and who do itemize (and are thus more likely even in the 35% tax bracket) – keep an eye on Obama’s current tax proposals, which may limit your deductions to the next lower tax bracket in benefit (http://www.nytimes.com/2009/02/26/us/politics/26budget.html?_r=1&hp).
So, get a sanely priced house, pay it off and take the standard deduction (75% do anyway). You still deduct your property taxes (up to the limit). Pick a state with no income tax (eliminating the only other item most have). Then put the $20K you aren’t paying in mortgage interest into your retirement fund. Let’s see who’s ahead at the end of 30 years…..
@ Tim / 56
Oh, all the ways to use the housing stimulus… there’s lots of possibilities. Certainly, if you looked at most advisors they’d recommend paying down your highest interest rate before using it any other way (note, most don’t include house and school in this discussion)… presuming you already have a bit of emergency fund.
How much do you think you can get from a single tenant? If you’re worried about ‘getting over your head’ you should look at your ability to afford the payments based on 2, 1 and 0 payments and look at your likelihood to fill the space.
@Wise Money Matters / #54
Of course, you’re right, those are all valid points. I don’t deny any of that – my issue was merely with Carrie’s assertion that you “can make up any time you missed in investments with higher amounts invested later.” In fact, you’d have to invest a grossly disproportionate amount “later” to make up the difference, due to the lost interest compounding.
With respect to the concerns you raised, however, I still believe that insurance can mitigage them to an acceptable level. For example, if I have an emergency fund that covers 6 months expenses, plus adequate short/long term disability coverage and life insurance, then isn’t stretching out my mortgage an acceptable risk? If I get laid off, then employment insurance combined with my emergency fund (and reducing my discretionary spending) should enable me to keep paying my mortgage for at least an entire year. Is it really likely that I’d remain unemployed for a whole year?
And if I’m injured and can’t work, well, that’s what disability coverage is for. If I were to die and leave my wife with 25 more years of mortgage, that’s what life insurance is for (I’m covered for roughly 2x our outstanding mortgage balance). Thus, I think with the right planning and foresight, taking your time to pay off your mortgage *is* the superior strategy over a long term.
I’m not sure about all the numbers, but it can’t be approached strictly from a detached numbers calculation (in my opinion). There is a peace of mind factor that can’t be entered on your 1040. Plus there is the freedom aspect that ought to be considered. I have a friend who works in the banking industry. What he really wants to do is sell bicycles. Selling bicycles doesn’t pay that well so he sells financial investment instruments instead. He is working to pay off his house so he can do what he wants one day.
J.D.,
I get the point of the article but I think the math is still wrong, I just tuned in so I don’t know what edits have been made. But if the standard deduction is $11,400 it is not required that amount is met with mortgage interest only (I think that is the assumption that is made at the beginning of this post) Your total deductions have to exceed $11,400 before you can enjoy the tax advantage of mortgage interest. So in my case we were able to deduct about $7500 in mortgage interest, but we were also able to claim deductions because my wife and I teach, and several other deductions.
After all deductions were totaled, to include our mortgage interest, we had about $11,800 in deductions. So, our mortgage helped us itemize, but only to the tune of $400. So I agree with the premise of the article that keeping a mortgage for the sake of deductions is a flawed plan. Furthermore, if you choose to purchase an easily affordable home (one of the biggest indicators of people who will reach financial success) you will most likely never be able to pay enough interest to itemize your deductions.
On a separate note JD I noticed your subscriber rate has jumped nearly 2000 in the past week!
Paying down your mortgage doesn’t just reduce your risk, it also drastically reduces the total actual amount you pay for your house. We will be saving around $122000 in interest payments by paying our mortgage down aggressively and reducing the total mortgage length from 30 years to a bit over 9. We are 5 years into it already. I can’t get used to seeing that number, we will be paying $122000 less for our house! The tax savings we would get is nowhere close to that.
Kevin – your numbers make sense, but even in the “lousy” first scenario, the guy ends up with a paid off home and $2.5 million in the bank. All of these scenarios end up with someone in excellent shape, so I don’t think it’s unreasonable for someone to choose paying off his home simply for the extra peace of mind and reduced hassle involved.
I mean, if you retire at 65 with $2.5million in the bank and no mortgage payment to make, and your friend retires with $3.2 million in the bank and no mortgage payment to make, you guys can still take your retirement trip to the Italian riviera for six months together.
Chett,
I specified “assuming you received no other deductions” at the end of that section. Of course people will have different deductions but there is no way to compute that in the article as people have a huge variation of deductions. For instance, I donate a little over 20% of my income to charity. This is a huge deduction and assists in my itemization. The person next to me may be single, with no kids and doesn’t give any money to charity. The assumption is he has very few, if any, deductions.
@ wise money matters #54,
All those things you listed are “highly likely” to happen? Uh, no. Possible, yes. High likely? Come on.
It’s fine that paying off your mortgage offers you peace of mind and that you have zero risk tolerance. That doesn’t mean it is the slam dunk best financial decision.
In fact, the only way your scenerio of paying off a mortgage early = less risk is true would be if you use the money that could be going towards your mortgage on discretionary spending instead. It is much LESS risky if you invest the extra money at a higher rate of return in assets more liquid than a home.
If you have all other debts paid off and are fully funding all your retirement accounts and paying off your mortgage early is what you want to do with your extra money, by all means. But stop trying to pass it off as the best financial move, because in most cases it simply isn’t.
@Wisemoney
Gottcha, I missed that at the beginning. I completely agree with the argument you make. My wife and I bought our first home at age 19. The cost, $38,000 and our monthly payment was $288 after our down payment. My grandpa praised us for buying a home because “that is smart and you can deduct that on your taxes” We lived there five years and never deducted a dime. Infact when I figured what we spent as a down payment, the upkeep on the house, and our monthly payments to include taxes and insurance, we would have been better off renting and drawing interest on the money we spent on a down payment.
If the premise here is to argue you should pay-off your mortgage as soon as possible then you’re right. However, the caveat of paying off your highest interest debt first and moving down the line should have been noted. That’s the basic premise being discussed, honestly. The idea you should build an emergency fund and once the fund is built work on paying off all debt. Its pretty simple and applies to this too.
Further, all the examples seem to be far from accurate portrayals. Like someone noted you pay to live in the house, and you pay interest to pay for borrowing the money. Having a tax deduction helps in that it isn’t there for renting.
The sole reason for buying a house shouldn’t be a tax deduction but after the tax deduction you can pay a higher mortgage and still net better than rent. I’m not going to do the math but if you get a refund of 4K, you can technically pay 330+ more in mortgage and end the same with an asset.
Lastly, this whole sub-prime issue and talking about having a bad mortgage or separate from the tax question. Sure, if you made a bad decision that changes thing. And taking money out of your house to use in stock investments is about the most foolish thing I’ve ever heard of.
Seems like you can solve the liquidity problem by saving the amount you would be paying down your principal with – once you accumulate enough, you can pay off your loan all at once. Interest on that account means you can even accumulate faster. Meanwhile, if you have a medical emergency or other immediate need for the money, you have not tied it up in your illiquid house.
I ignored the scenarios, however the ideas are spot-on. To have a house paid off, no payment, is a huge bonus. A lot of bad can befall a person, and if you still have a roof over your head which is paid for, you are well ahead in the game.
I think often of my grandparents, who were about as poor as poor can be, however their house was paid for and even on the meager money they received each month, they did not want for anything and were still able to give us all $5.00 for Christmas or our birthdays. (Yes, that was well over a quarter century ago.)
All those folks who want to carry a mortgage – let them! When I go into retirement I will have long past paid off the mortgage and will have been socking away years of “payments” into a safe, secure account.
You shouldn’t keep a mortgage just for the tax deduction, of course on the other side, how many tax deductible experiences get to leverage your investment and provide a place to live.
It is the leverage that a mortgage provides that is what is so valuable.
Seriously??? How can you ever trust an accountant who didn’t get something as elementary as this?
When it comes down to it, I would rather have the safety of knowing that if the economy crashed and I had to work at McDonald’s for the rest of my life, I could still survive just fine with my current lifestyle.
There is no way to know that this is true, unless of course you don’t plan on paying real estate taxes, or for electricity, heat, a/c etc. All it means is that the bank won’t foreclose.
Where I live a home can easily have $10,000 in real estate taxes (annual)
I agree with the crowd saying that it’s a weak argument to keep a mortgage. I didn’t read all the comments but had anyone brought up the idea of actually saving or investing what was once your mortgage payment once it’s paid off? Not only would I have the sense of security of having the house paid off, you fight your liquidity issue by not spending what you used to spend on a mortgage and save it.
Folks, there is an ENORMOUS difference between an accountant making a mistake on taxes (for which I pay him good money) and an accountant skimming a blog post to be sure the premise is sound (for which I pay him nothing). I agree that he should have caught the marginal tax rate thing, but so should I. This isn’t a fire-able offense. It’s the sort of thing to razz him about for years to come. I have no doubts regarding his competency, and do not hold this against him.
@Josh
I’m not saying ALL of those things are highly likely to happen to you, but one of those things (or similar types of situations) are likely to happen within your lifetime. You may not lose your job tomorrow but you will likely lose a job in your lifetime. You may not get into a tough accident, but you may have family members that do which require lots of money and time devoted towards them. Something will go wrong. That’s almost for certain.
But noting that, I do agree that it’s not the “slam dunk” best financial decision. Do what works for you.
What I’m saying is having a paid off mortgage is much less risky than investing the same money in stock. If I have $500 extra to put either towards my mortgage or stocks, I myself might put them in stocks to make them liquid. However, if I have $100K in stocks and my mortgage is $100K, I’d rather cash out and pay off my mortgage (barring any tax issues of course).
I just don’t think that the idea I’ve heard a lot from money blogs and even people I know that it’s better to keep money in stocks than pay off your house because of the “higher return”. Sure you CAN get a higher return, but if you look at the last year, it simply doesn’t always work. Then when the hiccups in life happen, you are out in the cold.
It goes to the whole idea of J.D.’s blog. You can get rich quick if you have a high risk tolerance. You are also more likely to lose a lot of money. I can buy a lottery ticket but the risk is so high to lose my “investment” that it’s not worth it. You can get rich quicker by keeping a mortgage and investing in stocks, but with a paid off mortgage, you are virtually guaranteed a safe and secure future regardless of what the economy does. It might be the slower path to riches but it’s the stable one. Remember: Get Rich Slowly.
But in the end, do what works for you and your risk tolerance.
I like Kevin’s analysis although it ignores tax deductions from the equation and the increase / decrease in value of the house.
What is missing here is that you need to also understand the effect on your overall net worth especially if you are going to compare renters and home buyers. Buying a home when it is losing value or is only increasing by a very small percentage over time (even with the tax deduction) is still not winning. You need to actually take into account all of the variables to see if the final number is higher or not (with plenty of assumptions).
Also…owning a house for 30 years comes with different costs compared to renting…upgrades, painting, extension, new flooring etc etc…vs moving expenses.
Simple numbers don’t always tell the whole story.
There are a lot of ways to look at this dilema, although I have never encountered a single person who expressed regret over paying off their mortgage early.
Some people want the security of having paid off their mortgage. While one might have a lot of money tied up in an asset that is not very liquid, the same person has generated a very attractive chase flow – as mortgage payments are no longer necessary.
If one wants to argue that a greater return could be had by investing extra mortgage payments in the market, they could very well be correct, but there is considerable risk in that venture. Just think if one year ago you had paid $50,000 against your mortgage versus placing the same $50,000 in an index fund. You would be very happy today….
I came into some money and completely paid off my mortgage. I’m now 100% debt free and I definitely sleep better at night as a result.
There is a positive psychological effect to living a lifestyle that you can afford and systematically eliminating all debt.
I have to say that you buy a home for that purpose to have a home not a tax deduction, and for all of the guru’s out there that say they get a “better return investing there money” I bet there not investing 800 dollars a month in investments to make up for the 800 worth of interest there paying out. I would like to see your REAL statement over the last 10 years not just the select few that years that look great on paper, consider the market has come down well over 50% in the last year and a half, wiping out years worth of growth that potentially could take years to regain. And there are many years of stagnant growth through out history. Paying off your mortgage makes cents! Leverage is a stack of cards and the wrong move can make it fall and it ussually is NOT in your favor. Why would you give a bank/mortgage company 600+ dollars a month, how can you say that is a wise “investment”. Part of this housing problem is the fact that we look at a house as an investment and speculate we could never lose any money.
30 years is a really long time, which is why the absolutists on either side make me uncomfortable. I think of paying down your mortgage as a fluid goal that is part of your overall debt/investment strategy.
You can’t put a dollar value on the peace of mind of having your home paid off, but that doesn’t make it *priceless* any more than it makes it *worthless*.
The premise of the article, that the tax implications of mortgage interest as an overwhelming reason not to pay down your mortgage is silly, is a good one. But that doesn’t mean that the tax implications should be taken out as a factor in your decision making.
And back to 30 years being a long time, all of you people comparing the value of stocks right now to the relatively stagnant value of homes don’t seem to be allowing for the fact that this is an a-typical drop in the market. It may take a while to recover, but to me that is an argument for the other side, invest in stocks while the price is low as long as the rest of your financial house is in order (Efund etc). Because in a couple years I bet people will be saying, “In march 2009, if you had invested that $10k in the S&P500 instead of your house you would have so much more money!” You need to look forward from here, not back. And since none of us know what is in the future, that is where doing what you’re comfortable with comes into play.
There are stupid decisions, but I see this as a matter of choice any hypothetical you throw out that *proves* payoff or investment is better can have holes shot in it with completely reasonable adjustment of the premise (change an interest rate, have an expense, lose a job, etc).
I find this article fascinating, but also strange because I get the impression that the “typical” mortgage in the USA is so different from what we have here in Australia. (I know this won’t be relevant for people in the USA, but it’s fun to compare notes.)
In Australia, most people have variable interest loans (they don’t tend to fix their rates, or if they do, only for a couple of years for the security of knowing their monthly repayments while their mortgage balance is at it’s highest).
Interest charged on mortgage for your home (as opposed to an investment property) is not tax deductible (but interest on your investment property is, it’s part of the cost of investing. It does not make sense to prepay the mortgage on an investment property if you want to remain negatively geared).
Finally, prepaying the mortgage doesn’t result in a liquidity problem because most mortgages offer a “redraw” facility or a separate “offset” account, where you can park extra money in your mortgage (or the linked offset account) and it reduces your mortgage balance, but you can then redraw money if you need it later. You still have to make the minimum monthly repayment, but you have access to the money you’ve “overpaid” should you need it in the future (say for house extensions or you lose your job or whatever). So we don’t have an emergency fund per se, because we know we can redraw from our mortgage – and although we would then be charged interest because our mortgage balance has gone up, our mortgage interest rate is still higher than the online savings accounts like ING.
Whether you could do better by investing elsewhere, rather than prepaying your mortgage, is still relevant though.
When we bought our house 10 years ago, my goal was to try our best to have the house paid off in full in 10 years. For the first 7 years, we put smaller amounts on top of the regular payment. We still had college loans to kill. After those were done, we started putting bonuses on the loan, and other large amounts as they came in. Well, I’d like to say that it’s paid up, but we’ll still have about 2 more years to go. However, we will be less thatn 50 years old, and conceivably will live in the home for another 30 years or so. There will be no problem spending the mortgage money…we’ll have 2 girls in college, and we have plenty of travel goals.
We do have our emergency fund in place, and college savings as well. Hopefully, we stay employed and universal health care finally becomes a reality for Americans, so we don’t have to drown in that cost as we age.
For military families who own their homes, and likewise for clergy serving in religious capacities, there is a whopping housing deduction called parsonage. people in those categories benefit doubly from home-ownership and mortgage paying.
I agree that the mortgage deduction is a big part of why we’re in our mess, giving people incentives to get far more house than they need. And since people often go to unreasonable lengths to pay less taxes and feel like they’re winning one against Uncle Sam, they often get more house than they can afford.
One of the problems we have is the govt. uses the tax code to encourage or discourage the behaviors they approve or disapprove of. We need a tax system that is fair and completely does away with tax breaks for behaviors approved or disapproved of by the powers that be. JMHO. Then, this would be a moot point and people would buy or not buy homes based on reasons that make more sense in the long run.
I didn’t get a chance to read all of the posts, but from what I read, it appears that an important factor was overlooked–itemized deduction phaseouts.
For married couples earning over $159,950 or single/married filing separately $79,975, itemized deductions are reduced through a process called phaseouts. This significantly offsets the value of a mortgage interest deduction for people earning good incomes.
In addition, those at the lower end of the income spectrum also fail to reap the full benefits of mortgage interest deductions. The reason is that they miss out on much of the itemized deductions from state income taxes (lower income) and their homes usually have lower values resulting in lower property tax deductions as well.
Plus, if you live in a state without state income taxes, you are further limited in your itemization benefit.
If you’re familiar with Monte Carlo planning, you’ll understand that carrying a mortgage into retirement makes ZERO sense because it significantly reduces nest egg longevity on the probability spectrum…but that’s just financial geek speak.
I’ll put together a post tonight to explain it all.
Great discussion on a terrific topic. For the record, I hate CPAs that recommend keeping a mortgage. Hopefully a financial advisor can show them the Monte Carlo analysis that proves this out.
I just put the post up and it should successfully debunk the myth of keeping a mortgage in perpetuity for the ‘valuable’ tax deduction.
http://www.wealthuncomplicated.com/wealthuncomplicated/2009/03/tax-myth-keep-your-mortgage-invest-the-tax-savings.html
Whenever someone talks about keeping a mortgage for the deduction, I always ask them if they would take a 0% mortgage if they could get it, or would they keep paying the interest and getting the deduction. That usually clears things up.
Just like any other financial decision, your actions need to fit within your goals, plans and risk tolerance.
For a personal example some very good friends, after purchasing a new home in 2002 had been very aggressively paying down their mortgage. They had planned on having it paid off this coming summer when he lost his job about 18 months ago. By the end of the next week they had set up to refi
(taking no cash out) their home into a 30 year fixed with a payment much lower than my rent.
Some posters have argued that paying a mortgage early “ties up cash” into the value of the property, which can be true, but in this very unexpected situation my friends have been able to make small adjustments to their lifestyle to accommodate as 60%+ drop in income. In a way they were able to create a sort of emergency fund, no the money paid on the house was not liquid emergency funds but the effect was probably more beneficial. Personally I think that was money well spent, in combination with an emergency fund they are relatively well situated to weather economic trouble.
My two cents:
No one should buy a house just to get the deduction–this is obvious, and I don’t think anyone actually does this. You (should) buy a house to have a house.
With that said, the mortgage deduction, in essence, makes your loan much cheaper. If I’m paying 5%, but I get to deduct 25% of it, then it’s really a 3.75% loan. At that rate, I would do better paying off almost any debt and (in a normal market) taking most reasonable investing opportunities.
I realize this is a little late, but I just wanted to say I appreciate you not blaming your accountant for this, J.D. Everyone makes dumb mistakes. In college, I was the editor of our school’s literary journal (published annually). I had spent hours proofreading it, making sure everything looked just so, working with the designer to get everything to the printer. We were really pushing deadline, and the printer called me in to do one last glance before it printed. I had already seen it all before and was about to leave on a trip, so I looked it over quickly and gave them the ok. When the books were ready a few weeks later, the word “review” in the title was spelled wrong ON THE COVER! I hadn’t noticed it, the artist hadn’t noticed it, the printer hadn’t noticed it, the account manager hadn’t noticed it. Now, we all knew how to spell review. Sometimes, big things really do just slip by. And in the end, I just accepted responsibility and tried to laugh about it. What else could I do? Since then, I’ve been much slower to judge others’ mistakes. In a way, I’m glad it happened.
Kevin,
I couldn’t agree with you more. Any time your are paying a lower mortgage percent than you will make investing, invest. Couple comments
1. injury, job loss, etc. You are still better off investing the money. The cash you have from investing is liquid. You can sell your stock that day and have money for bills, etc. If you’re paying off your mortgage your equity is not liquid. It may take months, or years in this market to sell your house. If you are injured or have no job you can’t wait that long to get the cash.
2. The money your using to pay off that house was taxed. Unless your over the 30,000plus limit for married couples for your 401k that 2176 extra principal payment (26112 a year) will save you another 6528 a year in taxes (25% bracket). And with compounding interest will easily take care of the taxes you will pay when you withdrawal.
Unless your paying over 10% on your mortgage investing is better. Kevin’s explanation was spot on and still did not include tax deduction on mortgage interest, the tax deduction on 401k investments, incentives for things like college savings plans, having easy access to your money, etc
Bottom line. Keep your mortgage for the interest deduction. Listen to your accountant.
Michael,
In response to your post:
http://www.wealthuncomplicated.com/wealthuncomplicated/2009/03/tax-myth-keep-your-mortgage-invest-the-tax-savings.html
I could go through this site and debunk nearly everything written. But, after reading it did make some sense.
I think this is one of those situation’s where “if you have to ask you probably shouldn’t be doing it”.
In a nutshell if you lack the knowledge to know if you should keep a mortgage and invest the extra principal, you probably lack the knowledge to understand how to invest the money, how to tax shelter it, etc. So in this instance you probably are better off just paying off your mortgage.
Two things to take away:
“any hypothetical you throw out that *proves* payoff or investment is better can have holes shot in it with completely reasonable adjustment of the premise (change an interest rate, have an expense, lose a job, etc).”
“the mortgage deduction, in essence, makes your loan much cheaper. If I’m paying 5%, but I get to deduct 25% of it, then it’s really a 3.75% loan. At that rate, I would do better paying off almost any debt and (in a normal market) taking most reasonable investing opportunities.”
One other issue is that buying a house is one of the few highly leveraged investments available to most people. In 1994, I bought a house for $10,000. Actually I paid $75,000 for it, but I borrowed the other $65,000. Ten years later we sold that house for $235,000. There is nowhere else I could have got that kind of return on a $10,000 investment.
Of course, the person who bought that house may well be under water now. Leverage works both ways. Which leaves this last take away that is just plain wrong in the context of paying down your mortgage:
“the amount of risk you are taking when investing your cash into a single asset (your house) is much greater than say, spreading it out over the market in an index fund.”
If a home’s value has dropped $100,000 when you sell it, you lose $100,000. The loss is based on the home’s value, not “your cash” in it. That risk from the house is the same no matter how much is left to pay on the mortgage or whether you have invested money elsewhere. But if you have money invested elsewhere you take on the additional risk from that investment.
I had a variable-rate mortgage, and paid extra whenever I could. Each year the payment was recalculated, and it went down. Even when interest rates increased, my house payment decreased each year because I had paid down the principal.
This increased my security two ways: Lower principal meant I was never ‘underwater’, even as house values dropped, and the lower payment meant that if I lost my job I could work at McDonald’s and still make my payment.
I am amazed at those who still advocate borrowing money on your house to invest, which is the exact same thing as choosing to invest extra money rather than pay down your debt. A hypothetical 8% return in the market is not the same as a guaranteed 6% return from paying down your mortgage.
The mortgage interest deduction encourages irresponsible behavior, and is partly responsible for the giant mess this country finds itself in.
“A hypothetical 8% return in the market is not the same as a guaranteed 6% return from paying down your mortgage.”
For anyone in the marginal 25% tax bracket the actual return is 4.5% if their mortgage rate is 6%.
“The mortgage interest deduction encourages irresponsible behavior, ”
This moralizing is really annoying. There is nothing “irresponsible” about taking on higher risk with the possibility of higher rewards. Buying a home is taking on risk regardless of how you pay for it. Leveraging that investment adds to both the risk and the rewards.
Any business can deduct the interest they pay as an expense. I suppose that encourages “irresponsible behavior” as well. We have had a mortgage deduction for a very long time. So you need to look elsewhere for the causes of the “giant mess” we are in now.
“For anyone in the marginal 25% tax bracket the actual return is 4.5% if their mortgage rate is 6%.”
(Sigh). A penny saved is a penny earned. It does not matter what tax bracket you are in. The rate of return on paying down your principal is exactly equal to your mortgage interest rate.
“It does not matter what tax bracket you are in. The rate of return on paying down your principal is exactly equal to your mortgage interest rate.”
Put simply, if you pay off $100 on your mortgage you save $6 in interest, but you would have got $1.50 of that back on your taxes. So your effective savings is only $4.50 or 4.5% of your $100.
Of course you also have to pay taxes on any money you make from investments. So, unless you are investing in tax-exempt accounts, you need to consider taxes in your effective rate of return from other investments.
No. The reasons for carrying a mortgage are:
1. When you’re renting, you’re paying someone else’s mortgage – and not having anything to show for it.
2. Tax breaks.
3. If you don’t have a mortgage, it looks much more attractive for potential lawsuits.
4. You own your home.
5. If you like to improve your home, at the end you’ve added value to probably your biggest asset.
6. This can be a great enforced savings plan for retirement, IF you’re willing to move to a smaller place or rent later in life.
I realize that some of these don’t apply to the idea of buying a home and paying off the mortgage. I’m sure you realize which ones. The reasons for not having a mortgage are:
1. Usually rents are lower than the mortgage payment – sometimes lower than the interest part of that mortgage payment.
2. You are paying a dollar to save 30 cents or so.
3. If you don’t take care of your home, you will push the value down of possibly your biggest asset.
I find that usually I do things because of several reasons, not just one… So I weigh all sides and figure out what’s best for me.
“Put simply, if you pay off $100 on your mortgage you save $6 in interest, but you would have got $1.50 of that back on your taxes. So your effective savings is only $4.50 or 4.5% of your $100.”
Let’s see if you can follow me here.
At the beginning of the year, we each have a $100.00 mortgage at 6%, and $100.00 cash.
I said that the rate of return on paying down your principal is exactly equal to your mortgage interest rate, and you say no.
So let’s say I pay off my mortgage, and you invest your $100.00 and get a rate of return exactly equal to the mortgage interest rate. At the end of the year, I have no mortgage, paid no interest, and paid no tax.
You make 6% on your $100, but you had to pay 6% on your mortgage. Plus, you had to pay $1.50 in income tax, but you got a $1.50 mortgage interest deduction.
Here we are, at the end of the year. My balance is zero. You still have your $100, but you still owe $100, so your balance is zero, too. You made 6 bucks, but you had to pay 6 bucks interest; you had $1.50 in income tax, but it was wiped out by the $1.50 deduction.
So we are exactly equal. The only difference is that you think the mortgage interest deduction saved you $1.50, and you’ve spent the year telling everyone so writing comments on blogs.
Further, for many married homeowners the standard deduction is so high that the savings from the mortgage interest deduction is worthless, or worth little.
“So we are exactly equal.”
Only if the return on my investments is only 6%. If they are 8%, I will pay $6 in interest, make $8 on my investments and pay $2 in taxes and save $1.50. I am ahead by $1.50.
But we were talking about YOUR return, which is still 4.5%. The actual return on alternative investments depends on a a variety of circumstances.
If I make tax exempt investments, I won’t pay any taxes at all. If I invest in stock, I won’t have to pay anything on the return until I actually sell it. At that point, I will be paying the capital gains rate on the appreciation not my income tax rate.
Like most other readers, I completely agree with the premise that the tax benefits alone are not a good reason to avoid paying off the mortgage or to purchase a home.
Regarding this same issue, I created a simple table that helps illustrate the extent of the tax benefits at http://www.yourtwobits.com. For those who are visual people, it may help.
@Michael C:
Great insight on your post…it does make the whole thing easy to understand.
Like you, I’ll gladly send my .28 to the IRS and pocket the .72 instead of paying $1 to the bank and saving .28 in taxes.
If someone really wants to avoid paying the IRS extra money though, contributions to a church or charity are every bit as deductible as mortgage interest. At least then the person can choose where they want their money to go instead of having the decision made for them.
It’s not a good idea to ask the professionals. Too many of them are simply ignorant.
Financial planners don’t know how to handle bear markets and their advice iks worthless.
Stockbrokers don’t know what to buy or sell – if they did, they would not be salesmen – they’d be wealthy and retired.
I think many can figure this out for themselves.
But there’s one more important factor. Comfort. If you feel better with no mortgage, that’s worth a great deal in leading a satisfied life. If it turns out that it costs a few dollars to make this choice, it’s well worth it.
Man, I almost wish my mortgage was higher. I don’t really have an incentive to pay my mortgage off early b/c my mortgage is about as much as most people’s car payment ($320).
And being only 25 there are more things I’d rather spend my money on today although I do have a couple investment accounts (well actually only my 401K and Roth IRA)and at least 2 months of emergency funds (which I am actively growing ASAP to at least 6 months)–I had financial issues recently that included buying a house, needing a new car, and being laid off, then hired at a higher salary…all in the last few months; so my savings has suffered, going from 20k to about 2k.
Hunkering down to pay off my 63k 30 year mortgage just isn’t that motivating especially since my mortgage is already lower that virtually all rent in my area, and barely makes a dent in my monthly expenses.
I’m nearing retirement and single due to my wife passing. I thought buying a house would help save me from paying so much in income tax now and when I do retire.
When making financials decisions you should definitely look at the whole picture and not just the tax implications. I have always said that if you are paying a lot of taxes you are doing something right.