To pay off your mortgage or not to pay it off—that is the question. And it’s one that financial advisors are often asked, especially in the current environment. A rule of thumb is that you should retire your mortgage before you retire from your job, but that may not be the case for everyone.
It is true that with mortgage rates moving higher, it is tempting to pay these loans off now, compared to one year ago. However, you should consider a few important factors before deciding what is wise when it comes to your mortgage payoff plans.
Factor in the Tax Impact
You probably want to figure out your real mortgage rate prior to looking at other factors. According to The Tax Foundation, 86% of taxpayers take the standard deduction.1 If you take the standard deduction, this makes it easy to determine your real rate since there is no tax impact with your mortgage. You can simply look at your stated mortgage rate to know your real rate.
If you do itemize, you can determine your real mortgage rate by using an online calculator such as https://www.bankrate.com/mortgages/mortgage-tax-deduction-calculator/ For high-income taxpayers with lots of other deductions, such as charitable contributions, the true rate of a mortgage may be much lower than the stated mortgage rate. This is because you may be receiving a tax deduction for your mortgage interest.
It’s important to note that most people are only allowed to deduct mortgage interest up to either $375,000 or $750,000 of their mortgage balances, depending on their tax filing status.2 The bottom line though: is that you never want the “tax tail” to wag the dog, but tax consequences need to be part of the decision-making process.
Expected Investment Returns
Let’s get one thing straight: no one can know for sure what future investment returns will be in stocks over the next few years. However, you can make reasonable guesses about what returns might look like in the long-term future, such as 30 years or more. Historically though, stocks have delivered attractive returns that have outpaced trend-line inflation.3
The trade-off to factor in is the opportunity cost. If you use cash to pay off a mortgage, instead of investing in assets such as stocks or real estate, you guarantee a return by simply not having to pay the interest. However, the odds are that you will likely earn a higher rate of return in a diversified portfolio of stocks. This is the opportunity cost decision for you – do you take the guaranteed return that will most likely be lower over time, or trust history to continue where future investment returns outpace inflation?
Your mortgage interest rate may be an inflation hedge.
There is one silver lining with the high inflation rates – the higher inflation reduces the true amount of debt you’re paying. Here’s how it works: the long-term fixed-rate mortgage provides an inflation hedge because the risk of inflation is assumed by the lender rather than the borrower. Over time, the lender (the mortgage company) receives payments that are less valuable, due to rising inflation. In effect, this makes a long-term fixed mortgage more attractive to hold than when inflation rates are lower.
Don’t overlook potential emotional benefits.
Make sure you don’t underestimate your emotions when making financial decisions. There is an intangible benefit of knowing that you don’t owe any money on the house you’re living in. For one, you may find that you sleep better at night by no longer holding a mortgage. Greater peace of mind and freedom from debt can increase your well-being, which can be especially valuable heading into retirement.
Make the right decision for you.
To help you make the right decision – you should answer two crucial questions about your mortgage:
- If I pay off my mortgage, what will I do with the money that is no longer needed for the mortgage payment?
- Would paying off my mortgage and re-directing these funds to something else, such as my retirement plan, give me greater confidence and increased peace of mind?
If you choose to get rid of your mortgage payment, make sure you have a plan to deploy your extra cash flow smartly. For instance, you may decide to increase your retirement goal funding or, if you have younger kids, you may consider putting this extra money towards a college savings plan.
By considering these factors, you should have the essential information you need to make a smart decision with your mortgage. Of course, it’s always a good idea to discuss all decisions with your current advisors so they can provide perspectives that may be missing.
Sources:
- https://taxfoundation.org/standard-deduction-itemized-deductions-current-law-2019/
- https://www.irs.gov/pub/irs-pdf/p936.pdf
- https://www.dimensional.com/us-en/insights/will-inflation-hurt-stock-returns-not-necessarily
The content of this article is developed from sources believed to provide accurate information. The information in this article is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. All expressions of opinion are subject to change. This content is distributed for informational purposes only, and is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.
