Pay Off Your Mortgage Early? Maybe Not

Many home owners pace the floors thinking of how to pay off their mortgage early, also known as prepaying. Everyone, at some point, has ostensibly been told to reduce mortgage debt as quickly as possible in order to be in a better financial position. Instinctively, we all buy in to the old school logic that paying off the mortgage before retirement and therefore owning our largest investment free and clear makes for the perfect plan. While this notion seems acceptable, let’s look at what some view as unorthodox alternatives to prepaying your mortgage.

Prepaying your mortgage may not be the savviest move financially. Particularly from a tax standpoint. This is especially true when faced with the choice of fully funding your retirement plan (401(k)) or prepaying your mortgage each month. This can even apply to the alternative taxable investment.

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.

Even if you are maxing out retirement account contributions, investing money in a taxable account may be smarter than paying off the mortgage early. A client who made a $110,000 profit on the sale of his home wanted to use the entire amount towards the purchase of a new $435,000 home in hopes of paying it off sooner. 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 (assumes 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.
Finally, don’t pay off that mortgage 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.

Of course, there is one caveat to the aforementioned scenarios. You must have the discipline to invest in order to make the most of not prepaying your mortgage.