Paying Off Your Mortgage Early

Gregory J. Cook, EA, CPA+ Accredited Tax Advisor Past President Alabama Society of Enrolled Agents Past President Alabama Association of Accountants

Considering the risk and volatility of the markets coupled with low interest rates, should I use my savings to pay off my home mortgage?

This seems to be a popular question this year. Our best guidance would depend on your individual circumstances, however as a rule of thumb here are some generalizations. If you are below age 45 and you don't view the current home as the last home you will buy, then lock in the lowest interest rate on your mortgage and keep the mortgage. If you are over age 45 and view your current residence as your retirement home, then consider paying the mortgage off early.
 
If I pay off my home mortgage, what impact will it have on my taxes by losing the home mortgage interest deduction?

The home mortgage interest deduction is a "personal itemized deduction" which is claimed on Schedule A along with other items such as, medical expenses, property taxes, tax on your car tags, sales tax on a new car, charitable contributions and employee business expenses, union dues, etc. Because the federal government will give you a Standard Deduction of $11,400 for a married couple or $5,700 for a Single taxpayer, you must exceed these dollar amounts before you gain any advantage. We really must look at this on a case by case basis to determine the outcome. Generally speaking, the taxpayers that would be hurt the most by losing the deduction are those people that have a lot of other personal deductions, for example those who give a significant amount to their church each year.

It is important to remember that for every $3 you pay in mortgage interest, the most you get back on your taxes is $1, so you are still out of pocket $2 financially speaking. At times it may be better to base your decision of whether or not to pay the mortgage off early on factors other than taxes. The interest rate you have on the mortgage is a big factor. For example, if your interest rate is 4.5% and you are getting the full benefit of the deduction, your true after-tax interest rate may be 2.97%.

Paying Off Your Mortgage Early Over Time
Could you afford to add a little more to your mortgage payment each month? It might be a good financial strategy for you. Typically, paying extra on your mortgage each month can save you interest and help you pay off the loan sooner. But, before you increase your mortgage payments, look closely at your loan's interest rate, your tax situation, and your complete financial picture.

Interest Rate
When you prepay your mortgage, in effect, you earn the mortgage rate on the extra money you pay. For example, if your interest rate is 9% and you decide to add extra money to your monthly payment, your pre-tax earnings on that extra payment would effectively be 9%. This means that you would be better off prepaying your 9% mortgage unless you could earn more than 9% by investing that extra money elsewhere. Before prepaying, compare your mortgage rate to the pre-tax rate you could earn from an alternative investment to determine which is the best option.

Tax Consequences
If you itemize income tax deductions and fully deduct your mortgage interest, you might not want to prepay your mortgage. By paying extra each month, you will be paying less interest overall and, as a result, your interest deductions will be reduced. In deciding whether to prepay your mortgage, you'll have to consider the effect of lower interest deductions on your income taxes.
If you are paying 6% interest on your mortgage and get the full benefit of the tax deduction, it really only costs you 4.2% if you are in a 25% federal and 5% state tax bracket.
It is important to remember that for every $3 you pay in mortgage interest, on average you will save $1 in taxes. Also, the federal government will give you a Standard Deduction in lieu of Itemized Deductions. Itemized Deductions consist of medical expenses, real and personal property taxes, mortgage interest on primary and secondary residences, investment interest expense, charitable contributions, employee business expenses and other miscellaneous deductions. Ascertaining the tax impact requires looking at all of these other deductions that you normally have as well.

Other Financial Conditions
Even if you decide that you can't earn a better return by investing your extra money elsewhere and you don't mind a smaller interest deduction, there are other factors to consider before prepaying your mortgage.

Everyday Expenses - Ensure that you have enough money for your everyday living expenses. Only money that you have in excess of your living costs should be used to prepay your mortgage.

Other Debts - If you have other debts at a higher interest rate than your mortgage such as credit card balances, personal bank loans, and auto loans, you should pay off the other debts before your mortgage, especially since the interest on those debts is generally not deductible.

Emergency Fund/Savings - You should have an emergency fund set up before you prepay your mortgage. If you will have to finance your children's college education or you are planning to retire soon, you may also want to build up your savings instead of prepaying your mortgage.

Other Options - You might consider refinancing your mortgage. If you can secure an interest rate lower than your current mortgage interest rate, refinancing could save you a substantial amount in interest charges and reduce your monthly payment.