All Things Financial Planning Blog

I am frequently asked if it is a smart thing to pay off the balance of my mortgage before I retire so I can save the extra money on my house payment and reduce my monthly expenses.

My answer is that it depends on several factors besides the monthly mortgage payment.  So in this blog I will try to present my perspective on what you need to consider in making this decision on whether you do or do not want to pay off the mortgage any faster than what was agreed to in the loan document.

When you decide to pay off the balance of the mortgage, you are using money that you have invested to retire a debt.  So the first issue is what are you earning on that investment and how does that compare to what you are paying as an interest rate on the mortgage.

Let’s say you have your money invested in a variety of stock and bond mutual funds and for the past three years the average rate of return was 6% on this portfolio.  By comparison, your mortgage interest rate is 6%.  On the surface, that looks like you are trading the same rates of return.  However, there are several underlying issues that you might want to consider before selling those investments to pay off the mortgage.

Mortgage interest is potentially deductible on your tax return, so we need to figure out what your effective interest rate is on an after-tax basis.  If you are able to itemize your deductions, the interest rate of 6% on the mortgage would be reduced by the incremental tax bracket you are in.  If you are in the 25% tax bracket, your effective interest rate on the mortgage is only 4.5% (6%-25% of 6%).  Should you be fortunate enough to be in the 28% tax bracket, the effective interest rate would be only 4.32%. 

So the question you need to be able to answer is “Can I make more than 4.32% or 4.5% on my investments on an after tax basis?”  If the answer is yes then that would suggest that you should not pay off the mortgage because you can earn more by keeping the money invested versus paying off the mortgage.

On the other hand, what tax rate are you paying on the investment rate of return?  If it is dividends and capital gains you received, the tax rate might be 5% or 15% depending on what other income you have on your return.  Or, maybe the growth was just in the value of your investments which did not create any taxable income this year – so there was no tax on the growth in your investment portfolio.

If only life was that simple.  Unfortunately, life is not that simple!  What else would enter the picture?

Let’s revisit the itemized deduction issue.  To be effectively able to take advantage of itemizing, your total deductions need to exceed the standard deduction that each of us is entitled to use when filing our tax return.  In 2009, that amount is $11,400 for Married Filing Jointly (MFJ) taxpayers ($5,700 if filing Single).  But this amount has two potential upward adjustments.  One adjustment is that you can add $1,000 for MFJ ($500 if Single) if your real estate property taxes are greater than that amount.  The second adjustment is if you are age 65 or older and/or blind.  For each of these events there is an additional allowance of $1,100 for MFJ and $1,400 for Single taxpayers to be added to the standard deduction.

If these apply to your situation, you may not get the full benefit of deducting your mortgage interest as part of your itemized deductions.  If both taxpayers were age 65 and older and blind while filing MFJ, the standard deduction would be $15,100 before adding in the $1,000 for the real estate tax adjustment.  This is $3,700 more than the standard deduction for those below age 65 and not blind.

Another consideration related to mortgage interest is that each year as you pay down the mortgage, the amount of mortgage interest you have to deduct will also go down making it less appealing to keep your mortgage in place.

If you do itemize your deductions and you exceed the standard deduction that applies to you, you may also want to look at how much over the limit you are. If your itemized deductions are $13,000 (including mortgage interest) versus the standard deduction of $12,400 (including the $1,000 for the real estate tax adjustment), you have really only benefited by $600 for your mortgage interest deduction – not the $7,000 of actual mortgage interest you had.

So perhaps you have done the math as it pertains to you and you conclude that using $50,000 of your investments to pay off the mortgage seems to be the right thing to do at this stage in your life.  Well there is one more consideration for you. 

If you pay off the $50,000 mortgage balance, you have used $50,000 of your investment portfolio to accomplish this step.  If a significant event occurred in your life that would require some or all of that $50,000 to be available, where would you go to get that money?

Several years ago, we would all have said that we could always get a home equity line of credit on our debt free house.  With the financial meltdown that we have all faced in the last few years, we might find that it would not be so easy today to get that loan from our friendly banker.  In this case it might be better to have not paid off the house and kept our money in our investments.

There is that old saying “A bird in the hand is worth two in the bush.”  Maybe it would be better to have the mortgage than to give up our money to get a debt free house.

If you were thinking of doing what this article was premised on, I would encourage you to consult with your professional tax adviser to be sure you are getting the full benefit of the mortgage interest deduction this year as well as in future years as the tax laws do change each year.  The same rules may not apply to you in the future the way they did last year or this year.

Francis St. Onge, CFP®
President
Total Financial Planning, LLC
Brighton, MI