Want to Pay Off Your Mortgage Early? Maybe You Shouldn't

The appeal of paying off your mortgage ahead of schedule is easy to understand. Why carry a big debt if you don't have to? If your mortgage permits prepayments without penalties, you may well be thinking of making some extra payments. Think again, though, because it's not always your best move.

Other investments, other returns
For starters, consider that if you have a mortgage with a 5% interest rate, any prepayments you make on that loan will essentially earn you a 5% return. That's great. But hold on -- you can make other kinds of investments and earn other kinds of returns. Is paying off your mortgage early your best bet?

The stock market, for example, has averaged roughly a 10% annual gain over many decades, and you can invest in most of the market via a simple, inexpensive index fund. Even if you only average a 7% or 8% return over your investment period, that beats the 5% from your mortgage prepayment. (And, of course, you might also average more or less than 10% in the stock market. There's just no way to know for sure.)

You might alternatively, invest in a few select stocks, such as ones that pay dividends. A healthy and growing company that pays out a dividend will generally do so in both bull and bear markets. It will typically increase its dividend over time, giving shareholders an ever larger effective yield. And it also offers stock-price appreciation. If you have long-term faith in the tobacco industry serving its addicted customers, you might consider Marlboro maker Altria (NYSE: MO  ) , which recently yielded 5.1% -- more than your 5% mortgage! (It has averaged annual gains of about 17% over the past 20 years, too.) Or consider New York Community Bancorp (NYSE: NYCB  ) , which is well regarded for smart management and has succeeded without ever receiving TARP money. The bank recently yielded 6%.

Better still, you might grab a solid dividend and instant diversification across many companies via a dividend-focused exchange-traded fund. The iShares Select Dividend ETF (NYSEMKT: DVY  ) and the SPDR S&P International Dividend ETF (NYSEMKT: DWX  ) recently yielded 3.1% and 6.9%, respectively. They charge just 0.40% and 0.45% in annual fees, too, and save you the trouble of selecting individual dividend-paying stocks by instantly plunking you into a big bunch.

One step forward, two steps back?
Another key consideration is any high-interest debt you might be carrying. If you've got a mortgage charging you 5% interest and a credit card charging you 20%, you should definitely put any excess cash you can toward paying down that high-interest debt. Extra money paying down your mortgage principal will indeed be like earning 5% -- but high-interest rate loans are the opposite of wealth-building. Instead of growing your wealth, they shrink it. (To be fair, they do grow the wealth of credit card companies.) Your credit card debt will grow by 20% annually if you don't tackle it aggressively, and at 20% a $5,000 obligation can become tens of thousands of dollars of debt in just a decade or less.

Speaking of interest, that's another factor to weigh when you're thinking of prepaying your mortgage. Mortgage interest payments are currently deductible on your taxes, reducing your taxable income. Thus, they benefit those in higher tax brackets the most. If you're in the 35% tax bracket and you deduct $5,000 in mortgage interest, that saves you $1,750. If you're in the 25% bracket, your savings fall by $500 to a still-not-insignificant $1,250. Keep in mind, though, that to reap this benefit, you must itemize your deductions. Many taxpayers don't do that, instead taking the standard deduction. When deciding whether to prepay your mortgage, run some numbers to see if it makes sense, tax-wise.

The authors of a recent study, "Unmasking the Mortgage Interest Deduction: Who Benefits and by How Much -- 2013 Update," state that only about 25% of taxpayers claimed the mortgage interest deduction in 2012. Among homeowners with incomes between $40,000 and $50,000, the average tax savings was just $54 per month, or a total of $648. The total revenue lost to the U.S. government due to the deduction was close to $70 billion, which is why some are calling for a reduction or elimination of the deduction.

The sure thing
Despite these and other reasons that might have you deciding to not prepay your mortgage, there does remain a compelling argument for doing so: It offers a guaranteed return. With bank accounts generally offering well below 1% in interest these days, and five-year CDs not offering much more than 2%, a guaranteed 5% return is nothing to scoff at.

There's no one-size-fits-all answer to the question of whether to pay down your mortgage early. Weigh the pros and cons in light of your particular circumstances, crunch some numbers, and see what makes the most sense for you.

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Read/Post Comments (9) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 09, 2014, at 2:17 PM, dbtuner wrote:

    debt freedom feels fantastic.

  • Report this Comment On January 09, 2014, at 2:34 PM, rickw4s wrote:

    To me, there are a few reasons to pay off debt:

    1. As mentioned at end of article: Its a Sure Thing.

    2. Stocks don't always rise: think Great Recession and Dot-Com bust... and "lost decade".

    3. Some people just do a lousy job picking investments.

    4. As mentioned by dbtuner: It feels good to not be in [much] debt.

    5. You want your mortgage paid off by the time you're ready for retirement.

    Yeah, yeah. If I could always pick investment winners, then yeah, paying down my mortgage would be a bad investment. Agreed.

  • Report this Comment On January 09, 2014, at 2:51 PM, Roofrep wrote:

    Best thing I ever did. (pay off my mortgage)

    I agree with rickw4s. Who can pick 100 percent winners? I know that paying off my mortgage earned me 5.5%. Plus the earning was tax free.

    Now I take ever 'payment due' and save it. Adds up pretty fast and if ever I want to indulge, I do so.

    Not only that, the feeling I own nothing - is fantastic.

  • Report this Comment On January 09, 2014, at 3:11 PM, Schneidku40 wrote:

    You may want to be careful with the tax savings statistics because they are simplified and don't reflect actual tax savings. A person in the 35% tax bracket never pays a full 35% on their taxes. Ditto for a person in the 25% bracket, 15% bracket, etc. Since the US tax system is progressive with the amount you make, even if you make $100k a year, you still first have to pass through the 10%, 15%, and 25% brackets as you earn money through the year. That's why people in the 25% tax bracket typically only pay 10-15% when it's all said and done (of course deductions help also).

    So a person in the 35% tax bracket in your $5,000 mortgage deduction example would likely save about 25%, or $1,250, and the person in the 25% tax bracket would likely save about 15%, or $750.

    I understand it's impossible to have an example like that and include effective tax rates that apply to everyone who might read, and in my example the difference of $500 is the same as what you got in your example. I just wanted to throw it out there.

  • Report this Comment On January 09, 2014, at 3:23 PM, dbtuner wrote:

    in addition to effective tax brackets as pointed out above, everyone gets the standard deduction anyway. So your mortgage interest savings have to exceed that number which is over $10K anyway.

  • Report this Comment On January 10, 2014, at 12:56 AM, rightgirl wrote:

    all your comments really make me think. I have managed to finally buy a house. I have been paying extra on my mortgage, But listening to what you're saying, it makes more sense to put that cash into my 401k. My situation is desperate because I just started building my future. I was married for 20 years and had to get out fast. I have managed to get a good job, but I'm scared. I need help!

  • Report this Comment On January 14, 2014, at 8:22 AM, wjcoffman wrote:

    It'd be fun to see the math behind "25% of taxpayers claimed the mortgage interest deduction in 2012 . . . total revenue lost to the U.S. government due to the deduction was close to $70 billion".

  • Report this Comment On January 16, 2014, at 12:58 AM, MtRon wrote:

    Schneidku40 was correct about the progressiveness of our tax system, but (s)he was wrong about the savings. If you are in the 25% bracket and you have a $1000 deduction, you will save $250 in taxes if you remain in the 25% bracket after the deduction and assuming you exceed the standard deduction. Deductions take money off the highest bracket as your taxable income is reduced.

    Another consideration is the tax favored status of qualified dividends compared to ordinary income. You can't simply compare a 5% deductible mortgage with a 5% qualified dividend that could be taxed as little as 0%, depending on your tax rate.

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