Perhaps you’ve received an inheritance, your company’s stock options have increased in value, or you’ve had strong appreciation in your investment portfolio over the past few years. You are now in the enviable position of being able to pay off your home mortgage, but should you?
Recent changes in the tax law will result in many taxpayers electing the standard deduction instead of itemizing deductions. (As a quick reminder, these deductions — standard or itemized — offset income for purposes of determining taxable income and thus the amount of tax owed.) Not only are the standard deductions higher under the new tax law but also several key deductions such as state and local taxes have been capped at $10,000 and other deductions (such as miscellaneous itemized deductions) have been eliminated. As such, many clients have called into question whether it makes sense to continue to have a home mortgage, particularly if they will no longer benefit from the home mortgage interest deduction.
As you can imagine, the decision to pay off your mortgage requires analyzing a number of factors but, ultimately, it may depend on your personal preferences.
The Argument Against Paying Off Your Mortgage
The most often cited reason for continuing to maintain your mortgage is that you will simply make more money by not paying it off. The key assumption is that investment funds you may have used to pay off the mortgage can remain invested and those investments earn a higher rate of return after taxes than the after-tax cost of your mortgage payments. If that sounds confusing, here is an example.
Let’s assume you can earn 7% annually on your investments and you are in a 40% combined (federal and state) marginal tax bracket. You have to pay taxes on the interest, dividends, and capital gains of your investments. We will assume for simplicity’s sake that your after-tax rate of return on your investments is 4.2% (7% less 40% in taxes). Now, let’s assume that your mortgage interest rate is 4.5%. Because you can itemize home mortgage interest, we can say that the true “cost” of your mortgage is not 4.5% but rather something closer to 2.7% due to the interest deduction (4.5% less a 40% tax deduction). From a financial perspective, if you can earn an after-tax return of 4.2% on your investments and your mortgage effectively “costs” you 2.7% after taxes, you are earning a spread of 1.5% annually. (Note that this example has been simplified and there can be a number of factors that make the true calculations more complex). That seems like a pretty good deal — so why not use the bank’s low-cost money in order to earn more money on your investments?
Many people follow this strategy successfully. Over a very long period of time, an investor with a well-diversified portfolio and good discipline may be able to come out ahead in this scenario. However, there is no guarantee that the investor will earn 7% and, in fact, he or she could actually lose money on his or her investments, in which case it would have been a lot better to have paid off the mortgage! Time is a critical component to benefiting from this strategy because, while investment results can be highly unpredictable in the short run, they tend to be more reliable the longer a person is invested. This is why maintaining a mortgage often makes more sense when people are younger and less sense as they get older.
The Argument in Favor of Paying Off Your Mortgage
Under the new tax law, the standard deduction for individuals is $12,000 and $24,000 for married couples. If the total amount of your itemized deductions (which include things like your mortgage interest, state and local taxes, and charitable contributions) is less than these standard deduction amounts, you will no longer itemize your deductions and will essentially lose the benefit of them.
If you have a mortgage and you are no longer itemizing your deductions because the standard deduction is better for you, the math on the previous example changes. Let’s say your mortgage interest rate is 4.5% but you are no longer itemizing your deductions. Your effective after-tax cost of your mortgage is 4.5% rather than 2.7% because you can’t deduct the interest. Thus, if you expect to earn 4.2% on your investments after taxes (7% less a 40% tax rate), you are now worse off by having a mortgage by 0.3% per year (4.2% after-tax investment return vs. 4.5% mortgage interest).
Paying more in mortgage interest than what your investments earn does not necessarily mean you should pay off your mortgage. There are many other factors to consider. For instance, you may expect to earn more than 7% on your investments. Moreover, by not paying off the mortgage, you can keep the funds in your banking or investment account and thus have more money available to spend or invest. Once you give your money to the bank to pay off the mortgage, it can require substantially more effort to get it back from the bank in the form of a cash-out refinance, home equity loan, or reverse mortgage.
As an aside, it is also important to remember that as you get closer to the end of your mortgage term, you are paying off more principal (which is not deductible) and less interest (which is deductible). Therefore, those who are deep into their existing mortgage term may be ideal candidates to pay off their mortgage.
Peace of Mind
The biggest non financial reason to pay off your mortgage is peace of mind, particularly if you are retired. Knowing that you do not have a monthly mortgage payment can be incredibly comforting because you know that you will most likely always be able to stay in your home.
From a cash flow standpoint, not having a mortgage payment also reduces one of the biggest monthly expenses for most people. With fewer financial obligations, you may be more willing to take some risk in your investment portfolio in order to earn a higher return or you may feel less nervous about big declines in the stock market.
Even if you come to the conclusion that you want to pay off your mortgage, there may be additional considerations. It may not make sense, for example, to pay off your mortgage if you have to realize huge capital gains to sell investments to come up with the cash for the payment. This decision needs to be weighed carefully. Tax issues can potentially change your thinking as well. For instance, your personal tax situation may change in the future such that you may be itemizing in one year and not in others. (As an aside, we find that ongoing charitable contributions can be a key factor when determining whether to pay off a mortgage or not.
More often than not, those who make charitable contributions regularly are often better off by continuing their mortgage. Most importantly, the tax law itself could change in a couple of years if the Democrats gain control of Congress and decide to reinstate deductions such as state and local taxes. A conversation among you, your advisor, and your accountant can often be very productive in helping you decide how to proceed.
Whether or not to pay off your mortgage is an important decision that requires careful thought and consideration of both financial and non financial factors. Your Cerity Partners team is well-equipped to help you think through this important issue.
Cerity Partners LLC (“Cerity Partners”) is a registered investment adviser with offices in California, Colorado, Florida, Illinois, Ohio, Michigan, New York, Massachusetts, and Texas. Registration of an Investment Advisor does not imply any level of skill or training. This commentary is limited to general information, and should not be construed as personal tax, legal, or investment advice. There is no guarantee that the views and opinions expressed in this piece will come to pass. The information is deemed reliable as of the date of this commentary, but is not guaranteed, and subject to change without notice. It should not be considered as an offer to sell or a solicitation of an offer to buy any security.