There has always been a raging debate about whether it is better to pay off your mortgage early or put your extra money into a 401k, the stock market or some other investment vehicle. There is no one right answer for everyone because many money factors come into play. As a person that has chosen to pay off the mortgage early, I find myself defending my position more often than having it supported. In an effort to bolster my defense, I have tried to bring together some numbers and ideas that will help me.
As an example, let’s consider a $150,000 mortgage loan. Let’s say it is a fixed rate 30 year loan at 7% APR with no penalty for early payoff. We’ll throw out points and fees to simplify things a little. Any amortization chart will show you that your monthly payment is $997.95. If you pay that exact amount each month over the life of the loan, you will have paid $209,263.35 in interest, plus the $150,000 principal amount of the loan.
Now, let’s say that you pay $300 a month on top of the payment, making it $1,297.95. At the end of the loan, you will have paid $100,219.88 in interest, a savings of $109,043.47. You will also pay the loan off nearly 14 years early. Here is a link to one of those online amortization calculators that lets you see what happens when you pay over each month.
Right off the bat, this appears to be a huge savings in interest at an average of around $7,269 a year for the 16 years that you will pay on the loan. You will also be free of the debt much earlier, allowing you to invest earlier with the money that you would have been spending on the mortgage. There are obvious questions about whether you can afford to pay that much over each month, what would you do with that extra money if you didn’t pay it on the mortgage, etc. But, let’s assume that you can pay that much over for most of the term and that you would have put it into some other investment if you hadn’t.
One argument for not paying off your mortgage early is the tax benefit. You can make use of mortgage interest when you itemize your deductions, so people assume that they would be losing a tax savings by paying off early and losing this deduction. But upon closer examination, the mortgage interest deduction may not be such a big factor.
The standard federal deduction for 2006 for married taxpayers filing jointly is $10,300 (an increase from previous years and it goes up again next year). This means that in order to itemize your deductions and claim your mortgage interest, your itemized deductions will need to come out to be greater than that amount.
You’ll pay $10,451.73 in interest during the first year of the loan if you don’t pay anything over, so you’ve easily eclipsed the standard deduction. Paying $300 a month over the first year, you’ll pay $10,333.95 in interest so you will still be able to itemize easily. However, as the life of the loan goes on, you pay more in principal and less in interest. In year 15, you will pay $7927.12 in interest if you don’t pay extra, leaving a wider gap to get up to the standard deduction. Consequently, you will pay only $1,649.43 in interest during year 15 if you pay over each month, which may be an insurmountable gap.
We also need to calculate how much money you actually save in taxes by making this deduction. Let’s consider the Kentucky income tax rate of 6% (assuming your income is over $8,001 a year) and a federal income tax rate of $12,020.00 plus 28% of the amount over $61,850 (assuming your income is between $61,850 and $94,225 and you are married and filing jointly). Using these numbers, you could be eligible to claim $3,378.00 in interest deductions in the first year if you pay nothing over. Your average tax savings over the 30 year loan is $2,254.50 per year. Here is a link to a calculator that helps you figure this one out. There is a big assumption here that tax rates will remain unchanged for the duration of the loan.
You are most certainly going to have a harder time beating the standard deduction sooner if you pay off early, meaning you may not be able to itemize deductions for as long a period of time. But, you only lose the difference between the standard deduction and your itemized deductions, not the entire value of your mortgage interest tax savings. Additionally, the gap between these two items gets smaller each year as you pay less interest and further still if the standard deduction goes up. So, even in the later years of being able to itemize deductions, the extra benefit gets smaller and smaller.
In short, the perceived tax benefit of itemizing deductions is most likely outweighed by the sheer savings in total interest payments over the life of the loan. Simply consider the average tax savings over the 30 year loan. $2,254.50 per year over 30 years is $67,635 – far short of the amount of interest we save by paying off early.
Another argument against paying off your mortgage early is that you could be earning a similar or better rate through other investments on that extra money. What you have to compare here is the after-tax cost of your debt versus the after-tax earnings of your investments.
To calculate the after-tax cost of debt, multiply the interest rate by one minus your tax rate. Your tax rate is your marginal federal income tax rate (28% in our example) plus your state income tax rate if you can deduct on that one, too (yes for Kentucky, 6% in our example). Here, the after-tax cost of debt is 7.0 x (1 – 0.34) which is 4.62%. So in order to beat that, your investments need to yield better than 4.62% earnings after taxes. Here is a link to that handy formula.
As with most investments, the key is risk. While you might hear that average long term returns from the stock market are 10%, there is always the potential to lose money, too. EE savings bonds, considered a safer investment alternative, currently pay a rate of 3.60% which is short of our target number. So, meeting or beating the target number comes down to guessing that your investments will do better. If you are willing to take that risk, then investing may be the way to go.
Private Mortgage Insurance (PMI) plays another role in the numbers. Assuming you did not pay the required amount down on the loan in order to avoid PMI (usually around 20 percent), you will be paying PMI longer on the loan if you do not pay over since it will take you longer to reach the percentage required to rid yourself of it. Clearly, paying the loan off early will save you some money in this regard.
Considering all we’ve discussed so far, you may be able to lean either way based on your particular situation or beliefs. Now come the X factors that sell me on paying off the mortgage early.
First and foremost, the stability of your income is paramount to paying off your loan. Are you sure that you’ll be able to afford the payments for the entire 30 years? Hopefully so, or you might not have taken the loan in the first place. But, consider the economy and your occupation. Personally, I am wistfully waiting for the day that my I/T job gets outsourced and I am out on the street. I like to think that I am skilled enough to find gainful employment, but flinging lattes at the Starbucks might not be out of the question. So, the sooner I pay off the mortgage, the better. Without that debt, I believe I could live comfortably on a much smaller income than what I earn today.
Second, consider how you would like to live. A lot of people look at me like I am crazy when I tell them that I pay extra on my mortgage instead of investing more money for retirement. A friend once asked me “Do you plan to work until you die?”. No – in fact, once I pay my mortgage off, I plan to do some additional investing for retirement and I might even work part time because I will be free of the debt much sooner! As long as you have the debt, you have limited flexibility in how you can live. Paying it off sooner means more choices for your lifestyle sooner. My response to my friend’s question is “Do you want to have to work and keep up the same income to support the same payments for 30 years?”
You must also consider the money you might save the sooner you don’t have a mortgage payment. We’ve all paid way more for a car than it was worth because we had to take a loan on it. Once the mortgage is paid off, you can save up and pay for a new car by writing a check. You’ll save yourself thousands of dollars in loan interest by doing so, while you probably would not have been able to if you still had your mortgage payment. Again, the sooner you can save money, the better.
Finally, the big one is the unexpected. Crap happens in life, and there is no telling when or why you might be in need of money for a big emergency. Again, the sooner you pay off your loan, the sooner you might be able to better survive a monetary crisis because you have more funds available.
Some people might argue that by paying over on the mortgage, you actually have less money available for emergencies than if you simply saved the extra cash. I would actually agree with that statement, but I am willing to take the shorter term gamble of paying that extra money on the loan versus having the loan for a much longer period of time. By paying off early, I am shortening the amount of time that I am vulnerable to a financial emergency. We could also argue that $300 might be too much to pay over each month if it leaves you with no emergency funds at all. It would be wise in any case to adjust that extra amount so that you still have some walking around money.
If you’ve read this far, you are probably crazy anyway so come join me! Stop gambling with investments for a while and start paying your mortgage down. The sooner you do, the sooner we’ll be able to live like kings without all that debt hanging over our heads.
