Friday, May 28, 2010

Why you shouldn't pay off your mortgage early

In an earlier post I mentioned that with a mortgage rate lower than 6% you should not pay off your mortgage early. After reading a few articles that mentioned 30 year conforming fixed rates falling below 5% and 15 year at 4.3-4.4%, this is a good opportunity to walk through the math behind my earlier statements.

Generally speaking, mortgage interest is tax deductible. There are some exceptions, but for the vast majority of Americans the deduction is quite significant. The mortgage interest and other itemized deductions qualified for must exceed the standard deduction for the individual tax filing status, otherwise it is more beneficial to use the standard deduction. At the current interest rate of 5%, a $100,000 qualifying 30 yr loan results in 1st year interest payments of $4966.49. Given these rates, it doesn't take a very expensive home to exceed the standard deduction. Use this calculator to get an idea of the yearly tax savings for specific set of parameters. Based on the tax bracket, the after tax interest rate of the mortgage is the mortgage APR times (1-marginal tax rate). So for a 5% mortgage and someone in the 25% tax bracket, the actual rate paid is closer to 3.75%. This is a "back of the envelope" calculation as it does not utilize the effective interest rate as well as the timing of the tax refund vs. mortgage payments. The mortgage is paid every month but tax refund is received significantly later in the following year, though this can be solved by adjusting the withholding rate. A more precise calculation would result in an actual rate somewhat higher, but not by much (probably around 3.8%).

This low actual interest rate is the reason I would generally recommend against paying off a home mortgage with a rate below 6%. The opportunity cost of this move is significant. If you have the capability of paying off more of the loan than required, you are forgoing the opportunity to invest that sum in an asset with a higher return. Your "investment" in your home by making additional payments is capped at a return of 5%, and it will in fact be lower than that, as shown above. Municipal bonds, which are generally federal income tax free, have significantly higher yields and are less risky than your individual residence. Finally, I personally view future inflation rates as highly likely to be significantly higher than the current 2-3%. Should inflation rise above your mortgage rate, you are effectively paying your mortgage off with more expensive dollars, further compounding the mistake.

Beyond the opportunity cost argument for not paying off your mortgage there exists an issue with the fact that additional mortgage payments can not be easily withdrawn at a later date. If, for example, you had been paying an additional $100 per month towards your mortgage for the past 5 years ($6000 total) and you lost your job or had some other emergency which required a significant amount of money, you can not access this $6000 without refinancing or presumably selling the home. Both of these options are likely impossible, difficult or costly on short notice. Had the money instead been invested in a bond fund, you could turn the entire position into cash within days while also earning a higher return than your additional mortgage payment. This same reasoning holds true for analyzing future expenses, such as car purchases or college tuition. The rates on home mortgages are lower than virtually any other type of loan for most individuals, implying that you should save the additional payments to pay up front for these expenses.

As a side note, the expected price appreciation or depreciation of your home has no bearing on this calculation as you will receive the same sale price regardless of the size of your mortgage.

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