Mortgage interest rates continue to hang around historical lows with a thirty-year loan under 5% and a 15-year loan under 4%. In addition to low mortgage rates, you receive a deduction for your interest payments from the federal government and, in many cases, the state as well. For example, if you have a 4.5% interest rate on a $200,000 mortgage and you’re in the 25% tax bracket, initially, your after-tax-saving effective interest rate would be approximately 3.4%. Now 3.4% sounds mighty low and most people’s first reaction would be to hold onto the mortgage but you need to put it in perspective of the bigger financial picture. Consider, for example, that a two-year CD is paying a paltry 1.5% and five-year CD is paying 2.5%. The typical money market savings account is paying one percent or less. So if you’re holding large sums of money in low paying accounts such as these, mathematically speaking, you could make the case for using the funds to pay off your mortgage. Of course, the correct answer is never this simple. Here’s a short list of things to consider before you make the decision to pay off your home mortgage:
- Do you have other debt? If you have any credit card debt, auto loans or similar consumer loans they almost certainly carry higher net costs than your mortgage. Strategically, you’ll want to pay them off first.
- Where will the money come from to pay off your mortgage? The more money you hold in low interest rate investments such as CDs, money market accounts and bonds, the more sense a pay-off makes. One question to consider is, “Where will interest rates be in five years?” Much higher is a pretty safe bet. It seems unlikely that the federal government will be able to continue to maintain the low interest rate environment that they have orchestrated over the past few years. So five years from now, your after-tax effective mortgage interest rate might be an excellent deal in relative terms. I’d also be very leery of depleting your cash resources to pay off your mortgage. You’ll want to make certain that you maintain an appropriate level of emergency reserves. If your source of funds is retirement accounts, rarely would this make sense because you’d likely incur an immediate income tax bill when you withdraw funds.
- Where are you in your mortgage cycle? If you’re at the tail end of your mortgage with just a few years remaining, the interest deduction is far less valuable since the lion share of your payments are going towards principal pay down.
- What are your other financial opportunities? Consider carefully your other financial options. Are you fully funding the matching portion of your employer’s contribution to your 401k plan? Would you be willing to invest more money in stocks? I would expect a diversified basket of high-quality stocks to earn more than fixed income or the net interest on your mortgage.
- The psychology of being debt free. Perhaps the best reason for paying off your home mortgage is if doing so will allow you to be debt free. Particularly if you are nearing retirement, being debt free is a worthwhile goal.