When evaluating whether to pay down your mortgage faster, you need to
compare your mortgage interest rate with your investments’ rates of return. Suppose you have a fixed-rate mortgage with an
interest rate of 6 percent. If you decide to make investments instead of paying
down your mortgage more quickly, your investments need to produce an average annual rate of return, before taxes, of about 6 percent to come out ahead
financially. (This comparison, technically, should be done on an after-tax
basis, but the outcome is unlikely to change.)
Besides the most common reason of lacking the money to do so, other good
reasons not to pay off your mortgage any quicker than necessary include
the following:
✓ You instead contribute to your retirement accounts, such as a 401(k),
an IRA, or a Keogh plan (especially if your employer offers matching
money). Paying off your mortgage faster has no tax benefit. By contrast,
putting additional money into a retirement plan can immediately reduce
your federal and state income tax burdens. The more years you have
until retirement, the greater the benefit you receive if you invest in your
retirement accounts. Thanks to the compounding of your retirement
account investments without the drain of taxes, you can actually earn a
lower rate of return on your investments than you pay on your mortgage
and still come out ahead. (I discuss the various retirement accounts in
detail in the “Funding Your Retirement Accounts” section later in this
chapter.)
✓ You’re willing to invest in growth-oriented, volatile investments,
such as stocks and real estate. In order to have a reasonable chance of
earning more on your investments than it costs you to borrow on your
mortgage, you must be aggressive with your investments. As I discuss
in Chapter 2, stocks and real estate have produced annual average rates
of return of about 8 to 10 percent. You can earn even more by creating
your own small business or by investing in others’ businesses. Paying
down a mortgage ties up more of your capital, and thus reduces your
ability to make other attractive investments. To more aggressive investors, paying off the house seems downright boring — the financial equivalent of watching paint dry.
You have no guarantee of earning high returns from growth-type investments, which can easily drop 20 percent or more in value over a year
or two.
✓ Paying down the mortgage depletes your emergency reserves.
Psychologically, some people feel uncomfortable paying off debt more
quickly if it diminishes their savings and investments. You probably
don’t want to pay down your debt if doing so depletes your financial
safety cushion. Make sure that you have access — through a money
market fund or other sources (a family member, for example) — to at
least three months’ worth of living expenses (as I explain in the earlier
section “Establishing an Emergency Reserve”).
Don’t be tripped up by the misconception that somehow a real estate market
downturn, such as the one that most areas experienced in the mid- to late
2000s, will harm you more if you pay down your mortgage. Your home is
worth what it’s worth — its value has nothing to do with your debt load.
Unless you’re willing to walk away from your home and send the keys to
the bank (also known as default), you suffer the full effect of a price decline,
regardless of your mortgage size, if real estate prices drop.
Don’t get hung up on mortgage tax deductions
Although it’s true that mortgage interest is usually tax-deductible, don’t
forget that you must also pay taxes on investment profits generated outside
of retirement accounts (if you do forget, you’re sure to end up in trouble with
the IRS). You can purchase tax-free investments like municipal bonds , but over the long haul, such bonds and other types of lending
investments (bank savings accounts, CDs, and other bonds) are unlikely to
earn a rate of return that’s higher than the cost of your mortgage.
And don’t assume that those mortgage interest deductions are that great.
Just for being a living, breathing human being, you automatically qualify for
the so-called “standard deduction” on your federal tax return. In 2011, this
standard deduction was worth $5,800 for single filers and $11,600 for married
people filing jointly. If you have no mortgage interest deductions — or have
fewer than you used to — you may not be missing out on as much of a writeoff as you think. (Plus, it’s a joy having one less schedule to complete on your
tax return!)