One of the major goals that most people have is to, at some point, be debt free. This is a goal that we (Chip and Erin) strive for in our personal lives and we highly encourage our clients to prudently consider as well. In fact, research has consistently shown that people with manageable debt levels tend to be happier than those who are burdened with a high debt load.
However, we have recently found that in people’s haste to aggressively pay down their debt, they may unexpectedly be making financial mistakes. With that being said, here are a number of things to consider when deciding on the appropriateness of paying off your mortgage:
The “Effective” Interest Rate of Your Mortgage
The combination of historically low interest rates and the deductibility of mortgage interest can make a compelling case to carry a mortgage. For example, the effective interest rate for a married taxpayer with taxable income of $90,000 (32% combined tax bracket for those in NC) and a 4% interest rate on their mortgage is only 2.72%. (see chart below)
While current interest rates on guaranteed investments like money market and CDs are currently lower than 2.72%, if you have a 30 year fixed mortgage, there will eventually be a time when interest rates exceed 2.72% and you may be able to conservatively earn more than your mortgage is costing you.
Retirement is a Debt Too (and a big one!)
Financial planning is a balancing act. Saving for retirement, saving for college expenses and paying down debt are all common goals that most people work towards over time. If you really think about it, each of these goals can be considered liabilities (or debts). Some are current liabilities (mortgage debt), while others are future liabilities (retirement, college).
From a financial standpoint, it can be counterproductive to only focus on making progress toward one financial goal at a time while ignoring others. We generally suggest picking away systematically at each of your goals. Making incremental progress towards multiple savings goals is also a great way to diversify your savings strategy.
Tax Consequences and Penalties
We strongly discourage paying off your mortgage with proceeds distributed from an IRA or 401(k) plan— especially for those under the age of 59 ½. Why? Distributions from IRAs or 401k plans prior to age 59 ½ will result in penalties and taxes that frequently exceed 45% of the gross distribution. That means it would require nearly $200,000 to pay off a $100,000 mortgage with proceeds from an IRA or 401(k).
Likewise, if you were to sell investments in a personal brokerage account, you may have to pay taxes on any capital gains that are generated prior to paying off the mortgage. Not only are you paying taxes to the IRS, but you are also permanently losing the future growth of this money.
Inflation Can Be Your Friend
We have long discussed the damaging impact that inflation has on your purchasing power. However, the fact that in 15 years, a dollar will buy less than it does today can work to your advantage when it comes to paying your mortgage.
After all, why pay down your fixed rate mortgage today (with dollars that are worth more), when you can make payments to your mortgage over time—with dollars that are actually worth less in the future?
The decision of paying off your mortgage early involves both financial and emotional considerations. We believe it is important for those contemplating this important decision, to carefully weigh the pros and cons. Feel free to contact our office should you have any questions.