Should I Pay my Mortgage Off Early? This is actually a FAQ – a frequently asked question, so I thought I’d spend a little time on it here. Some other mortgage-related topics we’ve addressed are these:
Let’s use a sample mortgage. $400,000 borrowed, at 4.5%, over 30 years. The monthly payment is $2026.74. That means over the life of the mortgage you will have paid $729,626.85 in principal and interest payments to repay that $400,000 loan – and, of course, $329,626.85 of that amount is interest.
You pay interest each month on the unpaid balance. In early years your payment is mostly interest, with very little principal repayment. In later years, situation reverses: you pay mostly principal, with much of the interest having been paid in the earlier years.
Using our sample mortgage, in the first year you will have shelled out $24,320.89 – your monthly payment times 12. Of that amount, $17,867.98 is interest, and only $6452.90 is principal. 73% of the payments went toward interest.
Skip ahead to the 20th year. You pay $24,320.89 out of pocket, but now $9171.93 is interest, and $15,148.96 is principal. Now only 38% of your payment is interest, with the balance repaying the principal of the loan.
What happens in the very last year of the loan? Of the $24,320.89 you pay out during the final year, only $582.59 is interest, with the lion’s share, $23,738.30, being principal repayment.
Now let’s come back to the original question: Should I pay my mortgage off early? Here are several considerations.
Clearly, even in the final year of a 30-year mortgage, there is an interest savings. When you take out a mortgage, you’re using someone else’s money to make a purchase. This is a bank lending you money to buy a house. The bank must make a profit on its investment, as any business does, so it charges you interest. No mortgage, no interest payment.
But what is the opportunity cost? Look at it this way: Say it would cost me $50,000 to pay my mortgage of early. If I do so, my actual return will be the interest rate on the mortgage – 4.5% in this case. My opportunity cost will be what I could/may have earned with those same dollars in an alternate investment. What would an investment portfolio have earned, for example? If I could have invested within my comfort level and risk tolerance and earned 9%, then I would be far better off investing, and continuing to pay off the mortgage.
Mortgage interest, up to $750,000 in mortgages outstanding, is an itemized deduction on Schedule A of your tax return. Currently (2020) a married couple has a standard deduction of $24,800; (half that for a single taxpayer). It makes sense to itemize deductions when they exceed the standard deduction. So, continuing our example, in the first year of the mortgage you’d have $17,867.98 of interest deduction. You can also deduct up to $10,000 of state and local taxes, so you could deduct the property tax on the home, and here in Florida, an amount for sales tax. Add to that your charitable contributions, and you may very well have an itemized deduction that is larger than your standard deduction.
So the mortgage interest deduction may very well factor into the decision to repay a mortgage early. A taxpayer needs to look at all the deductions available to make a wise decision.
When we work with a client, we gather both quantitative data and qualitative data. Everything so far in this piece has been quantitative data – numbers. But the qualitative data are often far more important. Continuing with that $50,000 payoff example above, you would save 25 mortgage payments – or just over two year’s worth. The earnings at 4.5% over those 25 months would be $4,904.63 before taxes. Might I rather forego those earnings in order to have a paid-up house? No further mortgage payment? Newly freed up cash flow of $2026.74/month?
Coordination with Retirement Date
This is a common goal: I want to go into my retirement with no mortgage payments. It may very well make great sense to increase principal payments each month, while you’re still working, in order to be mortgage-free in retirement.
Generally, No. All the dollars distributed from your IRA are taxable as ordinary income. Under 2020 tax rates, for a married couple the 12% rate ends at taxable income of $80,250. The next rate is 22%. So if your IRA distribution causes you to go into the next tax bracket, you’re going to be paying taxes to save on interest.
Let’s continue with that $50,000 example above. You are over age 59 1/2, so no 10% IRS penalty. The entire distribution falls within the 22% bracket, so in order to net $50,000 you have to distribute $64,103. You would have saved yourself roundly 25 payments of $2026.74, or $50,000. You will have cost you $14,103 in taxes for that peace of mind. Was it worth it? Would the remaining IRA balance be sufficient to fund your retirement?
Clearly, it makes less sense to distribute from a retirement account and pay taxes than from a non-tax qualified account in order to pay a mortgage off early.
We applaud everyone who wants to wrestle with debt and get rid of it – be it student loans, credit cards, or mortgages on primary residences. The decision to repay early, though, is one that should take some thought – one that should evaluate both the quantitative and qualitative data. This is the work that we do for our clients.
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