The answers to the questions you have always had about your personal finances.

Throughout the year we will address a personal finance, tax, or investment topic that personally affects you and your overall financial well-being. These articles will be laid out in a way that everybody can understand and apply to their own real life finances.  We at Bergerson Tax Services, Inc can help you with all of your personal finance and tax related needs. Please fell free to contact us anytime.  This month’s topic is

To pay off my home, or not to pay off my home, that is the question.

 

By Jeff Bergerson, Bergerson Tax Services, Inc

This question is asked more than any other personal finance question.  You have probably heard a million different theories from a million different people.  But what is the right answer?  The simple truth is it depends upon your situation.  This article will clearly lay out all of the factors to help you decide which would be best for you.

Your home is one of the biggest investment decisions you will ever make.  Deciding to keep a mortgage or pay it off could affect your whole financial life and might mean earning or costing yourself hundreds of thousands of dollars. 

With extra money should you put it toward your mortgage or invest the money?  Or, if you had enough money to pay off your mortgage should you?

There are several factors that need to be considered:

  1. Your time until retirement.
  2. Your mortgage rate.
  3. The rate of return you can achieve on your money invested rather than being put into your mortgage.
  4. Your psychological capabilities and your self-disciple.

To start lets take a look at a real life example and assume the following:  You have just inherited $250,000 that you can use to either pay off your home or invest into an investment account. You have just purchased a house with a 6% 30-year mortgage with a balance of $250,000 and you are in the 25% tax bracket. 

Interest on your $250,000 mortgage is $15,000 of which you can deduct $3,750 on your taxes because your taxable income goes down $15,000 (your mortgage interest paid deduction).  Your after tax interest cost therefore is $11,250.

Lets say you use the $250,000 to pay off your mortgage.  You no longer have any debt and have saved $11,250 after taxes.  In comparison if you keep the mortgage and invest your $250,000, the rate of return (the 3rd factor needed to consider) will be dependent on the type of investment you choose to put your money into and the amount of risk involved.  Historically a portfolio consisting of 80% stocks and 20% bonds has returned between 8-10%.  Lets assume an 8% return; you would gain $20,000 in the first year. You have to factor in taxes on that gain and the long-term capital gains and dividend rate is currently at a maximum 15%.  If you sold the investments after one year, that would leave you with after tax gains of $17,000.  We will use a taxable investment account for our purposes, but if you are able to invest your money in a tax deferred account such as a 401K, IRA, SEP, etc, your returns will be even greater.  By comparing what you save ($11,250) and what you would have earned had you invested the money ($17,000) you can see the difference for you is $5,750.

What makes this example even more powerful is when you factor in the power of compound interest over time on the money you invest.  Borrowing money at simple interest (as with your mortgage at 6%) and locking in the amount owed at today’s value can never balance with investing your present dollars to receive compounding returns for up to 30 years into the future.  The invested side of your balance sheet pulls ahead and leaves the debt side far behind.  Even if the interest rate paid on your mortgage and the interest rate received from your investment account are equal you are going to come out better financially with the investment.

To demonstrate the power of compounding, follow the example below:

There are two women, age 30, who both inherited $250,000 and they both decide to buy new homes priced at $250,000.  Both woman have full time jobs and have a steady salary.  The first woman, Priscilla Payoff has always been told that paying off your mortgage is the best solution so she did just that and paid cash for her home and does not have a mortgage.  She uses her salary to buy luxuries like an SUV and speedboat.

The next woman, Samantha Savvy has been talking with her financial and tax advisors and decides to invest her money rather than paying off her mortgage immediately.  Samantha put $50,000 down on the house and invested $200,000 in an investment account. Samantha uses her salary to make her interest only payments and lets her investment account appreciate in value.  At the time of purchase:

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Now that you can see the power of compounding and the power of investing money as opposed to paying off your mortgage, you will probably conclude that the no-brainer choice is to maintain a mortgage and invest your money.  I would like to touch up on a couple of factors that I mentioned earlier that may argue for paying off your mortgage.  Factor #1, Your time until retirement. If you are approaching retirement (5-10 years) you will most likely not be able to invest your money where you can achieve 8-10% Typically 8-10% gains come from stocks, which should not be the majority of your portfolio if the money will be needed in the short run.  The types of investments more reasonable for individuals near retirement would usually only yield between 4-5% (treasury bonds, money market, etc) making the strategy not as effective.  Also in the short run the power of compounding interest is not nearly as powerful as if you have a thirty-year time frame.

As for Factor #2 your mortgage rate and Factor #3 the rate of return on your investment account, if your rate of return that you achieve on your investment account is significantly lower than the rate you pay on your mortgage, this strategy will not be successful.

The other factor is Factor #4, which are your psychological capabilities and your self- discipline.  If you cannot sleep at night and you are completely stressed out by the idea of having your money invested in the stock market and more specifically in the types of investments needed to yield 8-10% you should not be in it.  If you cannot tolerate the sometimes-large fluctuations that the stock market sometimes produces go ahead and put your money into your house. If you constantly worry about debt on your house or think not having a monthly mortgage bill is your personal heaven, then pay off your mortgage.

Do consider a couple of additional things. Over time the stock market has proven to produce positive gains near 8-10%, but you need to wait out the bad times and just let the market work for you.  Next consider that home equity is relatively illiquid meaning if you suddenly need money for unforeseen circumstances and emergencies it is easier to sell a mutual fund in your investment account than it is to pull cash out of your home.

That leads me to my final point.  It is absolutely essential that if you choose to not pay off your mortgage and go the route of investing that money, you must, must, must actually invest it.  If you do not have the self-discipline to invest every penny and think your desire to buy a new S.U.V or luxury boat will be to great than you need to put your money into your home.

In summary, if you have a long-term time frame (over ten years) until retirement and you have the psychological capabilities and disciple to invest all of the money that would have gone into your home and your rate of return on your investment account is equal to or greater than your mortgage rate, you will be better off investing your money than paying off your mortgage. You will need that long-term time frame to absorb the market fluctuations and achieve the time tested market yield of 8-10%.  So take all of the previous information, factors, and illustrations and apply them to your situation and decide which avenue is best for you.

Jeff Bergerson founded Bergerson Tax Services, Inc (BTS) eight years ago and pilots a rapidly growing practice in St. Paul, Minnesota. Jeff has written many articles offering tax related strategies, financial strategies, and business guidance. Bergerson Tax Services, Inc. provides individuals and small business tax preparation services, small business consulting, and tax planning. He can be reached on the web at http://www.bergersontax.com/ or by email at info@bergersontax.com