A home loan is the biggest financial liability most Americans ever assume, and paying off a mortgage is a long-term goal for many of us. The question then arises as to whether or not you should pay off your mortgage early. This is a fairly complex question, both due to the financial intricacies of paying off a mortgage and the role that our mortgages pay in many of our lives.
So, should you pay off your mortgage early? The received wisdom from decades past is yes. However, the contemporary reality of paying off a mortgage is a bit more complex, depending greatly on your financial position and your overall financial goals.
As it turns out, for many investors paying off the mortgage early isn’t the best possible idea. The issues arise in the interplay between your mortgage payments and your other investments, particularly your retirement accounts such as an IRA or 401k. The choice which often arises is overpaying the mortgage with the goal of paying it off early or paying into a retirement account.
Let’s explore this via a hypothetical example. Consider a 50-year-old couple in the 33% tax bracket who wishes to retire in 10 years. Their mortgage has $400,000 remaining and each is eligible to contribute $20,500 a year to their 401(k). Should they prepay the mortgage or maximize their qualified plan contributions? By maxing out the 401(k), the couple would have a nest egg of $625,000 at the end of ten years assuming an 8% rate of return. That is more than enough to pay off the balance of their mortgage, which at the end of 10 years would be approximately $175,000. In addition, the couple would have recognized a tax savings of nearly $60,000 from the mortgage interest and approximately $135,000 from 401(k) contributions. Alternatively, they could use the would-be 401(k) contributions to prepay the mortgage for 6 years. This gives them 4 years to save prior to retirement. If they earn 8% they end up with a paid-off mortgage and $402,000 and a lot less in tax deductions.
To explore this example a bit further: Even if you are maxing out retirement account contributions, investing money in a taxable account may be smarter than paying off the mortgage early. Take the case of a client who made a $110,000 profit on the sale of their home and wanted to use the entire amount towards the purchase of a new $435,000 home with the goal of paying it off more quickly. However, by financing the cost of the new home and investing the $110,000 over 20 years, our client would end up with approximately $520,000 (assuming an 8% rate of return). This would allow the remaining mortgage of approximately $200,000 to be paid off while leaving over $300,000 for future use.
As a final caveat: it is best to avoid paying off your mortgage early if the majority of your payments are tax-deductible. Assuming a 33% tax bracket, the after-tax cost of a 6% mortgage is about 4%. If you can earn greater than 4% after-tax, you are better off keeping the mortgage.
The executive summary of all this might read that the question of paying off your mortgage early is a tricky one, depending greatly on your individual position, situation, and overall goals. This is where our team of professionals comes in. Together we can help illuminate the blind spots on your path to financial success, regardless of your needs or goals. Get in touch today and we’ll guide you through any questions about your mortgage, your retirement, or your investments.