People often ask us if they should pay off their mortgage early. There is not a simple
answer. In some cases it may even make sense to take out a bigger mortgage. Let’s
see what the issues are. First, if available mortgage rates are significantly less than
your current mortgage rate you should probably refinance. Usually, if the differential is
at least 2 percentage points, it’s worth re-financing. It may also depend, however, on
how long you expect to stay in your current home, since the cost of points and closing
expenses to refinance may not be recovered.
Next, assuming your mortgage rate is competitive, you should be sure that you are not
carrying any credit card debt or high interest loans. These should be paid off before
considering paying down your mortgage.
Also, you need to be sure you are taking full advantage of tax-advantaged investment
programs such as your employer’s 401K plan, deductible IRAs and Roth IRAs.
If you still have money to spare, then you can decide whether to pay down the mortgage
or invest more in regular taxable accounts. The decision hinges on two things: (1)
whether you are comfortable taking on more risk and (2) whether you can earn a higher
rate of interest in the market than you are paying on your mortgage. If your investment
horizon is long and you aren’t concerned about taking on the additional risk of more
equities, then by all means invest more in your investment portfolio. On the other hand,
if you already have a great deal invested in the market and would only consider
investing in T-Bills, CDs or bonds returning 5% to 6%, then paying down a 7% or 7.5%
mortgage makes sense. Paying off the mortgage will provide a return equal to your
mortgage interest rate, normally with essentially minimal risk (assuming your home will
hold its value in today’s real estate market). It will also save you a substantial amount in
interest payments.
But what about the reduced tax deduction in mortgage interest that would be lost for
those who itemize deductions? Whether this is an issue depends on how tax efficient the
alternative investments are. If the funds invested in the market are not tax efficient, then
the income earned would be taxed at the same rate used in calculating the savings from
the mortgage interest deduction. In this case the reduced tax deduction is offset by the
taxes on the added income. If the money is invested in tax efficient index funds, then the
lost tax deduction would be a factor.
If you are comfortable taking on the added risk of investing additional funds in stocks,
then you will, over the long haul, likely do better than if you pay down your mortgage.
This assumes that stocks have historically returned over 10%, while mortgage rates are
usually much lower. Currently, however, many of Wall Streets’ sages tell us not to
expect double-digit returns on stocks during the immediate future.
Now, should you consider a bigger mortgage? You should first decide on your
personalized target portfolio and determine its expected long term return. If you’re
confident the expected after-tax, long-term return will be greater than your current
mortgage rate (which may be questionable given the current market outlook of some
experts), a larger mortgage makes sense. Of course, this is only if your budget can
comfortably support a larger monthly payment and you are comfortable with the added
risk of more money in the market. A rule of thumb many financial planners use is that
individuals should keep their housing costs (Principal, Interest, Taxes and Insurance)
less than 25% of their gross income. Any more than that and you could find your
budget is too tight.
However, if you’re like some people (many who are just about to retire) and like the idea
and peace of mind that comes from eliminating the monthly mortgage payment, then pay
it off, relax and enjoy your retirement years!
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, September, 2007
Should You Pay Off Your Mortgage?
By David and Erin Patterson