Maybe you are currently building wealth by contributing at least 15% of your income into investment and retirement accounts, limiting expenses, and now you find yourself with extra cash to invest. A question that comes up often is whether to pay down your mortgage, or invest the extra savings toward long-term accounts. First, this is a win-win situation — either scenario involves putting money in a productive place to potentially build wealth for your family’s future, but let’s dig deeper.
Due to the high cost of housing across the country 30 year mortgages are the norm, and recently I’ve read about 40 year mortgage options, which just seems crazy. This made me think, why are we so trained to accept the idea of paying back our mortgage over such a long period of time? It seems having a mortgage payment has become a fact of life today. Even when we find ourselves with extra money most don’t consider putting it toward their mortgage, rather it becomes money for vacation, clothing, electronics, etc., and getting rid of that looming debt is an afterthought. I believe this is because most haven't taken time to sit down and look at their repayment plan. We were sold a mortgage based on an affordable monthly payment and that’s all most of us ever look at. Do yourself a favor, find and review the amortization schedule for your loan. Over the life of the loan you’ll see that you are likely to pay as much in interest to the bank as the purchase price of your home.
We’ve all heard ‘the tax deduction is too valuable’, and, 'mortgage rates are low, invest your money in higher earning investments'. But, is the deduction really valuable? And, how much risk comes with making such type of investments?
The Interest Deduction
First, in order to qualify you must itemize deductions when determining tax liability. In plain words — everyone receives a standard deduction from the IRS, only when you have qualifying expenses that exceed the standard deduction can you itemize. The standard deduction FY 2017 is $6350 filing single, $12,700 married filing jointly. Second, this is a tax deduction and not a credit. A tax credit receives a dollar for dollar reduction in taxes, while a tax deduction lowers your tax by the percentage amount of your marginal tax rate.
Let’s look at an example:
- Interest paid is $15,000 and in this case total itemized deductions are $15,000.
- You would be allowed to itemize and the amount above the standard deduction (married) would be $2,300 ($15,000 - $12,700).
- Assuming a marginal tax rate of 28% your savings would be .28 X $2300 or $644.
Unless you have significant deductions you can see that there isn’t a huge savings impact. This strategy favors high-earners who own larger mortgages and pay more interest. On a side note, you may only deduct interest paid on a mortgage balance up to $1M.
Maintaining Debt In Favor Of Other Investment
Whether you realize it or not, carrying your mortgage debt in order to fund other investments is leverage. While the equity markets carry a risk premium in the form of higher potential returns you are in fact taking on a lot more risk, and there is no guarantee of any return on your investment. The 3 year standard deviation (volatility metric) of the S&P 500 is more than 10% and the 10 year is over 14%, compare this with no volatility on mortgage payoff returns. While risk is a personal preference, we prefer balance and diversification; remember you are already contributing 15% to your investments.
Paying down your mortgage will provide a guaranteed return in the form of saved interest, and, mortgage returns are fully non-correlated to the stock market. As mentioned there is no volatility on the return received by paying off interest.
Mortgage freedom can deliver long-lasting happiness; you cannot underestimate the intangible returns associated with paying off debt. Knowing that you don’t owe money to anyone or anything is an incredibly powerful feeling that can reduce levels of stress and anxiety as well as foster feelings of accomplishment. Mortgage freedom can also relieve a burden if you run into difficult circumstances, such as the impact from a layoff or other adverse event. Paying off your mortgage early is also a common route for those who are able to achieve an early retirement.
Future Income Stream
Is your home an income-producing asset? For most of us housing is our largest expense, reducing this cost creates extra breathing room in the monthly budget and can potentially change our need for income. This becomes especially important when considering retirement.
We feel there is a lot of value in paying extra toward your mortgage. So what is the approach and how much should I pay?
Establish An Ideal Payoff Date.
When do you want to have the house paid for? Just because you have a 30-year mortgage doesn’t mean you can’t treat it like a 15 or 20-year note. Use this date to determine how much extra you need to pay in order to meet the payoff date. Whether or not it is possible will be based on your available cash flow, but it’s still a great exercise to work through. This may also help determine how much of your additional monthly investments to use toward the goal. Perhaps you’ll find a balance that allows you to contribute to your mortgage payoff and put extra into your investments simultaneously.
Make Extra Payments
As we mentioned the early payments in your mortgage term will be mostly interest. Making additional payments on the principal at this point makes a HUGE difference. Making one extra payment per year on a 30-year mortgage can take 5 or 6 YEARS off the life of the loan. We recommend making things easy - if you’re more of a routine person, add extra to your payment. If you like to do things in bunches, make an extra payment once a year. Consider the following:
- Apply a bonus check or tax refund
- Increase your monthly payments to pay additional principal.
- Round up - simply increase your payment to the next round number.
A little bit at a time makes a big impact over the long-term. Please share your thoughts and experiences with us!
*The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All indices are unmanaged and may not be invested into directly. These are hypothetical examples and not representative of any specific investment. Your results may vary. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.