Home      Intro      Education Series      Advanced Topics      Blog      Giving Back     Services

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.
Topic Menu

The material on this website is provided for educational purposes only.  We make no guarantees regarding the accuracy, completeness, or applicability of any material presented on this website.  This website is not a substitute for individual financial or counseling advice.  You should seek the advice of a professional regarding your particular situation.  My Financial Awareness is not responsible for any losses, damages or claims that may result from your financial decisions.

Copyright © 2008 by My Financial Awareness, L.L.C.
E-mail questions and comments to pete @ myfinancialawareness.com