Should I Have a Mortgage?
Over the last few years, many financial advisors have suggested
making extra mortgage payments in order to lower the
amount
of interest
paid
over the life of the loan. Other financial advisors
(and tax advisors) have suggested that having a large mortgage (thus
keep the
loan
as long
as possible) is better in order to lower the amount of taxes paid. So,
who is right? It all
depends on your financial situation.
Key facts about a mortgage:
- Low cost loan - Mortgage interest rates are lower
than many other loan rates.
- Tax advantage - There are tax advantages
on mortgage interest rates. However, the tax effect should only be
viewed as lowering the interest rate you pay on the
mortgage, not as a way to lower your taxes. If
your mortgage rate is 7% and you are in the 28% tax bracket, the interest
that you
are
paying is really (7% x (1-28%) = 5.04%), if not subject to the alternative
minimum tax (AMT) or other deduction phase-out limits.
Believing that mortgages are a way to lower taxes is similar
to saying you are going to have children to get the tax
exemptions
and tax credits for having children. In reality, you will
pay much more for having children than you will ever save in taxes. Tax
exemptions and credits only lower the cost of having children. The
same goes with the tax deduction on mortgage interest; it
only lowers
the
mortgage interest
rate that you pay.
- Often necessary - Unless
you are extremely wealthy, you probably can not afford a home without
having a mortgage.
Now, let's discuss whether or not to accelerate
your mortgage payment.
Possible reasons for paying off your mortgage faster
than what is required:
- Reduce your interest payments - For a 30-year $200,000
mortgage at 7% interest, your payment would be $1,330 per month. Over
the life of the mortgage, you would pay back $478,800. By increasing
the payment to $1,440 ($110 extra per month or $1,330 extra
per year), the loan would be paid off in 23 years and 10
months. By
doing so, the total amount paid would be $411,800 (a savings of
$67,000). The
more you make additional payments, the more you will save
in interest costs.
- Lower your outstanding debt - By making extra payments,
you are lowering your debt and moving towards becoming debt free.
- Create extra disposable income -
One thing that few people talk about is that by paying off your mortgage,
you free up a large portion of your income to use for other purposes. Take
two examples:
Example #1 - You plan to pay off your mortgage just as your children
go off to college. If you were paying $1,000 a month towards
your mortgage, that money can go towards your child's education instead.
Example #2 - If paying off a mortgage in 18 years is too quick (for
your child's education), then you can pay it off before your retirement
so you need less income in your retirement years due to not having
a mortgage payment.
Reasons why some advise NOT to pay off your mortgage
- Cost of loan is lower- Due to the
tax advantages, you will have a hard time finding another loan at such
a
low cost. If
you lose your job and need a loan, you will probably be charged even
more due to having
a higher credit risk.
- Investment rate arbitrage - Instead of making an extra
payment towards your mortgage, take the extra payment and invest it in
the stock market instead. The
logic is if you can get a 10% return in the stock market and 7%
mortgage interest rate, then you are better off in the stock market. If
you invest long term, the annual expected after-tax return on the stock
market would
be approximately
8.5%
(assuming 15% capital gains tax rate) while the mortgage interest costs
would be 5.04% after tax (at a 28% tax rate assuming no AMT). This
difference in rates results in approximately 3.5% profit each year by
investing in the stock market instead of accelerating your mortgage payment
(assuming markets perform
as
expected).
- Higher net worth - By investing in the stock
market instead of accelerating your mortgage payment,
your net worth would probably be
higher due to having an extra profit as shown above. Having some
debt (e.g., mortgage debt) can be good if you can leverage it into
a higher net worth, assuming you
can
take
on
the
risk
of the
stock
market returns. For
example, in the case of making an extra $110 monthly payment on a $200,000
mortgage with 7% interest rate,
by
investing
the
extra
$110
per month in equities
instead (assuming they earn 10%), you would increase your net worth by
approximately $80,000 after 30 years (reflecting 28% tax bracket and
15% capital gains tax). However,
if equities under perform (i.e., stock market in 2000 to 2002), you could
lose money
as
well.
In looking at the advantages of each position, there may not be a clear
cut answer on what approach you should use because it will be dependent
on your circumstances and actual return on equities. To
help you in your decision think about the following issues:
- Emergency fund should come first - You should build
up a proper emergency fund first before making an extra payment towards
your
mortgage. This is because it is harder to get a loan when you really
need it (e.g., if you lose your job). And, if you make the extra
payment, the money is then not available to you for an emergency. You
will need to get a home equity loan or refinance your mortgage to gain
access to the money. Plus,
making the extra payment to your mortgage does not allow you to forgo
future monthly mortgage payments if you fall on hard times. By
having an emergency fund built up first, you have the cash available
that you need to pay your monthly expenses (including the mortgage) in
case
of
an emergency.
- Liquidity needs - If you will need additional cash
for college, a car or other reasons in a few years, then investing
in CDs or other short-term asset vehicles may be a better option
than making an extra mortgage payment. Once you make the mortgage
payment, you have locked in that money until you sell the home or refinance
the
mortgage (with the associated closing costs). By putting the
extra payment into short-term assets, you can use this money to pay
for college or to buy the car instead of getting a loan to do this.
- Which debt should you pay off first - Before
paying off your mortgage, make a list of all your debts with the amount
of debt and the net after-tax
interest
rate
for each. You should pay off the debt with
the highest interest rates first. This analysis can show
that a mortgage with a 7% interest rate (adjusted to 5.04% after
tax rate using 28% tax
bracket
and
assuming no AMT)
is a slightly lower cost loan compared to
a car loan with a 5.5% interest rate.
Thus, the car loan should be paid off first.
In this analysis, be sure to use the potential interest
rates. For
example, a credit card debt at 0% interest for 6 months and
18% interest thereafter should be paid off first because you
want the
credit card paid
off before the 18% interest rate hits. You may also want
to pay off a home equity loan with a floating interest rate
(e.g., currently at 5%)
paid off before the mortgage (e.g., at 7% fixed rate) if you
are concerned about a increase in interest rates (e.g., interest
rate on home
equity loan increasing to 8% or 9%)
Lastly, as mentioned above, you should also consider future
loans. For
example, if you are going to need a loan to purchase a new car
in 2 to 3 years,
factor
in this cost. It may make more sense to save your money
for a new car instead of making additional payments towards
your mortgage, only to take out a car loan later.
- Type of investments - Before listening to the experts
telling you that you can make money by investing instead
of repaying your mortgage, sit down with your investment advisor
to see
how your portfolio is allocated. Investing the extra payment
may be a good strategy for younger people who are invested
primarily
in equities
however may not be a good strategy for those
who are invested in CD's and bonds (e.g., those who are getting
closer
to retirement). If
you are considering investing in bonds or CDs, you may be slightly
better off paying off your
mortgage instead. This is because the return on bonds and
CDs are usually comprable or slightly lower than mortgage interest
rates.
Thus, the amount you save could be less than the amount you save by paying
off your mortgage.
In other words, the extra $110 payment towards your mortgage
can be viewed as a contribution to a savings plan with a return
equal to your mortgage interest rate. If you invested $110
a month into a savings plan at various rates, you will have the
following amounts at the end of 23 years and 10 months
( when mortgage is paid off under the bi-weekly mortgage plan).
4% savings plan - $53,000
7% mortgage interest - $80,000
8.5% return (stocks/bond mix) - $101,000*
10% return (stocks) - $128,000*
* Note, the outstanding mortgage after 23
years and 10 months without the extra payment would be
$80,000. So
you could technically pay off your mortgage with the investment
returns and still have money left over (if markets perform
up to expectations).
So, if you are young and invested
in equities or other high-return vehicles with no short-term
liquidity needs, than
investing the
extra payment instead of putting it
towards your mortgage may be
a good strategy (if you can handle the investment
risks of equities). However,
if you are (or will be) invested in more conservative assets
(e.g. bonds or CDs) that return close to your mortgage interest
rate, than paying off your mortgage can be better provided
there are no liquidity issues (needing the money for an emergency).
- Risk vs. Return preference - Depending on your risk
preference, a guarunteed return by paying off your mortgage may be
better than
a higher return that may or may not happen.
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