As a Financial Adviser one of the most common questions my clients ask is whether they should pay off their mortgage early when they have excess cash. It’s important to understand that there is no “one size fits all” answer to this question. There are many variables that play a role in whether you should pay off your mortgage early but here are some important factors to consider:
What is the Opportunity Cost?
Although it may be enticing to live debt-free, first consider the opportunity cost of paying off your mortgage early at the expense of your other goals or investment options, as well as the effect to your tax situation. There is a potential opportunity cost to paying off your mortgage early. Though you'll save on the additional interest expense by not having a mortgage and this savings can be significant, by throwing excess cash towards paying down a mortgage those funds are no longer available for investments. To determine the opportunity cost determine what the after-tax interest rate is on your mortgage and compare that what you could earn on a diversified investment portfolio customized to your risk tolerance.
What are the tax ramifications considering the new tax law?
The lower your interest rate, the less you stand to benefit from paying off the mortgage early. As many homeowners know, interest paid on a mortgage is tax deductible if itemized, but due to the new tax law almost doubling the standard deduction, this interest tax deduction means nothing unless your itemized deductions exceed the new standard deduction. The new limits on home mortgage interest deductions allows you to deduct interest on up to $750,000 of mortgage debt used to buy or improve a first or second residence. Luckily, the changes do not affect (1) home acquisition debt of up to $1 million that was taken out before December 16th, 2017 or (2) under a binding contract that was in effect before that date, as long as the home purchase closed before April 1st, 2018. Under another grandfather rule, the $1 million home acquisition debt limits continue to apply to home acquisition debt that was taken out before the new law and even afterwards, so long as the initial principal balance of the new loan does not exceed the principal balance of the old loan at the time of the refinancing. Many homeowners will be unaffected by the new limits on mortgage interest deductions. But folks with larger mortgages and home equity loans must take heed. Another hit to those owning property in California is that state law now limits the amount of property taxes, and state and local income tax, a person can deduct from their taxes. In the past, there really wasn’t a limit. But going forward, these deductions will generally be limited to $10,000. For many the ability to deduct mortgage interest is a key component to their tax strategy, taking into consideration the new tax law, consider whether you will still be able to itemize on your taxes without mortgage interest.
Let’s look at an example:
Suppose you are grandfathered in and can continue to deduct on up to a $1 million of home acquisition debt. Furthermore, the stated interest rate on your mortgage is 4 percent and you are in the new 22 percent federal income tax bracket. Your after-tax mortgage rate is roughly 2.9 percent, perhaps lower if you deduct the mortgage interest on your state income tax returns. For most investors, investment portfolios are constructed using a risk tolerance that carries a much higher annualized expected investment return than 2.9 percent so you will likely earn more from your investments.
What current life stage are you in?
For some, the "guaranteed" 2.9 percent savings is more attractive than a higher expected investment return, which could be subject to loss and market risk. You must evaluate what life stage you are in and what your overall risk tolerance is to determine whether the returns of your investment portfolio will likely beat the savings that would result from paying off your mortgage. But being debt-free may become more important later on in life and in the end you must be able to sleep at night knowing that you followed your intuition. I have come across many clients that cannot stand to carry debt into retirement and for those folks the stress of worrying is not worth the possible higher return from investing their excess money versus paying down their mortgage debt.
How disciplined are you with your money?
Realistically consider whether you'll invest the cash that would have been directed towards paying down your mortgage or spend it. Consider direct deposits into your brokerage account or IRA or increase how much you automatically contribute to your 401K. It’s important to automate this process so you do not forget or worse yet start to spend the money on things that don’t yield a savings or a return.
What are your goals?
It’s also imperative that you look at your other needs, besides the option of investing excess cash are there any other goals on the horizon? Examine your whole financial situation including credit card debt, student loans and whether you have enough money saved in your emergency fund so that you do not have to lean on credit cards in the future. Also, if you do plan to stay in your home for the long term, it makes more sense to consider overpaying your mortgage versus if you don't anticipate ever paying off the mortgage.
As you weigh the options, set realistic expectations and ensure the proper plan is in place to achieve your goals. Discuss the decision with your Financial Adviser and CPA before committing to a strategy. No matter which way you are leaning, remain flexible. If you're still unsure which direction is best think about opening an earmarked savings account for your excess cash flows and revisit the decision in a few months. There is always a middle line as well and you could use your excess cash to both pay down your mortgage and invest for your goals. At the James Financial group we can sit down with you and run the numbers to determine the best mode of action for you at this time in your life. If you are debating this important question you are always welcome reach out for a free consultation to see if we can help.