If you are like most Americans, one of your largest monthly expenses is your mortgage payment. For individuals, particularly those near or entering retirement, consideration must be given as to whether to maintain your mortgage or pay it off. This decision is guided by both psychological and financial factors, and for many is not an easy choice. The recent introduction of tax law changes has added another factor to consider when deciding whether to pay off your mortgage early.
Psychological vs. Financial Factors
Sound financial planning generally includes the tenant of eliminating debt. Not having a mortgage payment significantly lowers monthly expenses, leaving a homeowner with only the yearly responsibility of property tax and insurance. It is a good feeling to know you own your home outright.
While the “feel good” factor leads many to pay off their mortgage early, there are also financial considerations to be made. Given the recent period of all-time low interest rates, most homeowners have a very low mortgage rate. Financially, if you can earn more after-tax than paying off your mortgage, you are better off financially not paying off the mortgage.
A few things to consider:
- You must actually save the funds not used to pay off (or pay down) your mortgage in savings vehicle (brokerage or savings account). You can’t spend the money set aside to pay off or pay down the mortgage.
- You must earn an after-tax return that justifies keeping the mortgage. In the current environment, this will likely involve some stock market risk which you must be comfortable taking.
- Your after-tax return must exceed the mortgage interest rate less deductions. Historically, most homeowners have itemized their taxes. As we’ll discuss in the following section, this will not necessarily be true going forward. As such, the after-tax return may now need to exceed a higher rate of return than in the past which may impact your decision.
Tax Law Changes
For 2018, the standard deduction has increased from $12,700 to $24,000 for married couples ($26,600 if over 65) and from $6,350 to $12,000 for individuals.
The other two largest itemized deductions are for charitable gifts and state and local taxes. Under the new Tax Act, $10,000 is now the maximum deduction for state and local property tax.
With these changes in effect tax strategies may be shifting as projections show as many as 90 percent may now opt for the standard deduction, avoiding itemizing their deductions. Many families who choose to go this route will no longer be getting the “homeowner’s subsidy,” as a result.
So, should you pay off your mortgage?
For conservative investors and those nearing retirement, the increase in the standard deduction and mortgage interest limitations may now provide a greater benefit to paying off a mortgage. Many also have a financial goal to be debt-free in retirement, therefore paying off their mortgage may create peace of mind.
For more aggressive investors or younger couples willing to invest over a longer period, keeping the mortgage may make the most sense. For example, those with a 30-year time horizon estimating an average yearly return of 8% investing in the market may choose to avoid paying off their mortgage as their investments may generate better after-tax gains. Individuals with a low interest rate on their mortgage may also elect to save their money elsewhere such as savings or an emergency fund.
Let’s look at an example. Instead of paying off your mortgage, you invest these funds in an investment earning a hypothetical 6%. Your current mortgage rate is 3.5%. If you are in the24% tax bracket, the after-tax financial benefit of not paying off your mortgage is 1.90% if you itemize but only 1.06% if you do not. Higher rates of return may financially justify not paying off the mortgage, while an approximately 1% benefit may lead to paying off the mortgage.
|Itemized Deduction||Standard Deduction|
|Hypothetical Rate of Return||6.00%||6.00%|
|After-Tax Return (ST Gain)||4.56%||4.56%|
|Mortgage Rate after Tax Benefit||2.66%||N/A|
|After Tax Benefit||1.90%||1.06%|
Every situation is unique and recommendations will drastically differ depending on various factors, including time horizon, risk tolerance and personal preference. We strongly suggest consulting with your team at Republic, or your own financial advisor, in coordination with your CPA to better understand the potential implications of paying off your mortgage early.
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