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Burning the mortgage used to be a rite of financial passage, and owning your home free and clear remains an undeniable pleasure. Yet the question of whether to pay off a mortgage early usually involves taking a wider view of your finances. If you can afford to do it, should you?
Or with interest rates near historic lows, are you better off investing your excess cash where it might earn a higher return?
Calculating these tradeoffs starts with your current mortgage rate. Assuming there’s no prepayment penalty, paying off the balance yields a return equal to the interest rate on the loan. If that’s more than you’re earning on your cash, an early payoff might be worthwhile.
If you don’t have a fixed-rate loan, the equation is more complicated. Adjustable rate mortgages (ARMs) and interest-only ARMs have become very popular during the refinancing boom. With an ARM, you may need to factor in likely future mortgage costs. For example, you may be paying a low initial “teaser” rate with a requirement to make a balloon payment after a few years. Also, interest rates may rise.
But suppose your mortgage has a fixed rate of 5.75 percent and you owe $75,000. You happen to have $75,000 in a money market account paying 3 percent. That yields $2,250 a year, and if you’re paying the top income tax rate of 35 percent, you net $1,462.50. That’s an after-tax return of 1.95 percent.
Compare that with the return on paying off your mortgage. Though avoiding mortgage payments will earn you 5.75 percent, you’re giving up a deduction worth 35 percent of the mortgage interest you pay. Taking that into account reduces your yield to 3.74 percent – still almost double the after-tax return on keeping the cash in the money market account.
What about other options? Obviously, you should first use your cash to pay off non-deductible, high-interest debt. If you’re paying 12 percent or more on a credit card balance, wiping that slate clean is a no-brainer. However, lacking other debt, you may want to consider additional options. For example, assume the average yield on a 20-year tax-free municipal bond is 4.5 percent. That could be a better place for your cash, though with any investment you’re taking on risk. Municipal bonds are subject to both interest rate and default risks. Also, yields are subject to change, and they may be subject to alternative minimum taxes.
Risk is certainly a factor if you’re thinking about putting excess cash in the stock market. While stocks historically have outperformed bonds and cash investments over the long term, they also tend to be much more volatile, and prices have sometimes remained depressed for years.
So what’s the bottom line? Whether or not to pay off your mortgage depends on a range of considerations. Once you’ve weighed all the pros and cons, your decision may ultimately hinge on how you feel about debt.
If you don’t like debt, put away your calculator and pay off the mortgage. No payments, no worries.
But you must be the judge.
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