Things to Consider About Paying Off Your Mortgage or Should You Rent and Not Worry?

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Have you ever wondered if it makes sense to eliminate your home mortgage?

Did you think about the interest expense and try to justify it with a tax deduction? Have you considered how illiquid your assets are if your home equity is a significant part of your net worth? What is the opportunity cost of borrowing money to buy a residence? What could I do with the down payment instead of buying a residence? How much mobility is needed in your lifestyle? Will you be moving frequently? If you have a mortgage now and your investments aren’t earning more than the interest rate on the loan is it still a good idea to keep the mortgage?

So many questions but is there a correct answer? Simply put, probably not. Like so many facets of our lives one answer often does not materialize to make decision making easier. Over the last forty years I have discussed this issue in many meetings. There are formulas that can be worked to obtain present and future values of the variables involved.

To begin with, in my opinion, housing prices don’t always go up, inflation is not always covered by the appreciation in residential real estate, especially in Northeast Ohio. There was time when an encouragement to buy a house was that the payments on the mortgage would be made with dollars that decrease in value due to inflation and thus it wasn’t costing as much. We had many years where index returns in the major markets, S & P 500 being an easy one to cite, noticeably exceeded the APR on traditional fixed mortgages. If the S&P grew at 10% per year and your mortgage was fixed at 7% for 30 years the simple math would indicate that you should have been better rewarded for the investing surplus savings rather than increasing the down payment on the house, right? Doesn’t 10% exceed 7%?

This could be where it starts to become analytical. What is your effective tax rate? Let’s use 20% to help our discussion. If you are itemizing your tax return, that is using Schedule A when you file instead of just taking the standard deduction, then your effective, or after-tax interest rate could be 5.6% (7% x 80% = 5.6%), so in theory you only need to exceed 5.6% after-tax return on your surplus savings. There is a lot more involved, but for simplicity let’s just stay on this path. A 10% return on savings in a 20% tax bracket results in 8% (10% x 80%=8%) after taxes and 8% exceeds 5.6%, doesn’t it?

On the other hand, if your savings are producing minimal to negative yields should you redeem your mortgage? In the above example wouldn’t that be like making 7% on your money? It’s the rationale for paying off credit, right? Nobody likes to pay 14.95% interest, do they?

The discussion or argument for or against buying a home or paying off the mortgage early is very emotional in many respects. If you chose to rent and never buy what could that mean to you? In the later years of amortized mortgages your payment is mostly principal, right? The lenders make their money in the early years of amortized mortgages using the Rule of 78, so in the last few years it’s mostly principal being paid back. There are few tax advantages to be had at the end if tax deductions were why you justified buying a residence.

It’s the American Dream to own a house according to many. If you’re not sure what’s the right path, contact your advisor before you sign on the dotted line.