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Should You Pay Off the Mortgage?

Posted by Keith on April 12, 2007 at 9:25 pm  

Keith,

Should we pay off our mortgage? We sold stock options and the money is sitting in a bank account earning 6% for the next 5 months.

Should we use it to pay off the $270,000 we owe on our mortgage (at 7.5% interest)? Would you suggest some other, more beneficial use of this money? My husband is 55 and I am 50. We have no other debts and we have maxed out our 401k.

Thanks,

Debra

Dear Debra (from 180 Miles NW of Honolulu),

Helpful Math

First, multiply that 7.5 percent interest rate on your home mortgage by the inverse of your combined federal and state effective[1] tax bracket (just add the two rates) to determine the actual net-after-tax cost of your mortgage interest payments.

For example, if your effective combined[2] rate of federal and state taxation is, say, 25 percent (Example: 22 percent federal and three percent state), multiply your 7.5 percent mortgage rate by .75 (1-.25 = .75). That is, .25′s inverse is .75). Get it? TSo 7.5 x .75 = 5.63%. This is the actual net-after-tax cost of your mortgage.

This tells you that to justify keeping your mortgage, you must earn a net-after-tax total return on the equivalent of the mortgage amount (the money you would otherwise use to pay off your mortgage) of at least 5.63 percent on average year after year to break even. Some years you can do better or worse, as long as it all averages out.

That is not a particularly tall order if you are an equity investor, and if you invest wisely. But there are no guarantees, and you could find yourself financing a mortgage while losing money in the market.

Certainly, that six percent you are earning at the bank is not going to cut it. By the time you pay tax on that interest – assuming you are in the 25 percent effective tax bracket – you will only earn 4.5 percent net.

And that’s 1.13 percent less than the net amount you are paying on your mortgage. I know CDs are safe, but as we investment types like to say, “You are going broke safely.”

Meanwhile, your current mortgage interest rate sounds a bit high. If you keep a mortgage, you might consider a no-points, no-closing-cost refinance at a lower rate.

No Incorrect Answer

Now that I’ve confused you with facts, here is the important point: There is actually no incorrect answer to your question.

Mathematically, if your mortgage interest rate is reasonable, and if you are in a higher income tax bracket, and if you do reasonably well with your investments, you are better off to maintain a mortgage and invest the money.

However, you and your husband are at an age where culturally you may desire – and have every right – to just pay the darned mortgage off.

Over the years I have found people about split on this issue. You mentioned that you are “maxed out” on your 401(k), and you obviously have some non-qualified assets as well. You must ask yourself whether five or ten years from now you will feel comfortable having so large a portion of your net worth locked in a single asset – your home. Alternatively, you must ask whether you will want a mortgage payment then.

You might also consider cashing in your chips and paying off the mortgage when you both retire, but maintaining the mortgage and investing the difference in the interim – provided you get the money much more productively placed than in a CD (consult with your investment advisor).

Ultimately it comes down to two things: Common sense, and doing whatever helps you sleep well at night.

–Keith



 

[1] Yes, the last dollar of interest paid should be multiplied by the marginal tax rate, to find the marginal tax benefit. However, here we are looking for the net effect on Debra’s budget.

 

[2] Add your total state and federal taxes owed , and divide the total by your “Adjusted Gross Income” as indicated on your federal return. This result is your effective combined tax rate.


Comments

1 Comment so far

  1. Debra Krupp on April 14, 2007 10:23 am

    Thank you, Keith, for the food for thought. Not sure what we will do, but appreciate having some basic info to start from. Also, enjoy your time in Hawaii and beyond. We will be following your travels via this great website. Take care.

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