Mortgage: early payoff vs. invest

Once you've tackled your financial demons and you feel like your budget and lifestyle is manageable, you may begin to ponder where to put all this extra money you're saving.

Before your write a big check and mail it to the mortgage lender, take pause.

Things to consider:

What's your interest rate? If it's less than 5%, that's pretty good. If you originated your loan before 2017, the mortgage interest on the first $1,000,000 is tax-deductible. If your loan was originated in 2017 or later, the interest on $750,000 is tax-deductible.

(A Long Side-Note about Mortgage Tax Deduction: This only benefits you if your itemize your deductions on your tax return. If the standard deduction is more than the deductions you'd take for mortgage interest, charitable contributions, state and local taxes, then this isn't a compelling argument.

Even if you do itemize, your benefits may not be as large as the formula implies. See, only the amount of your mortgage interest in excess of the standard deduction really saves you any extra money on your taxes. For example, say you're married, your standard deduction is $24,000 and you have $6,000 in itemized deductions besides mortgage interest. If you pay $20,000 in mortgage interest, you benefit by itemizing because your $26,000 in itemized deductions exceeds your $24,000 standard deduction. However, instead of your mortgage interest deduction reducing your taxable income by $20,000, it really only reduces it by $2,000 because you could have claimed the standard deduction without it.)

Figure out your after-tax mortgage rate:

1. Subtract your marginal tax rate from 1

2. Multiply the result by your mortgage interest rate

3. This is your after-tax interest rate

For example: You fall in the 25 percent tax bracket and your mortgage interest rate is 5.5 percent. First, subtract 0.25 from 1 to get 0.75. Then, multiply 0.75 by your mortgage interest rate of 5.5 percent to find the after-tax mortgage interest rate is 4.125 percent.

In this case, when you pay off your mortgage you get a guaranteed rate of return of at least 4.125 percent. This is an investment in the known versus the unknown (we don't know what the stock market return will be this year).

On average, the stock market returns between 6-8% over a decade or more. In this example, you can get a better return on your investment by putting the extra money in your brokerage account but you can't live in a stock. The relief and peace of mind of owning your home outright is plenty compelling for some people. And if your interest rate is higher, the argument for stock investment is less convincing.

Here's the flip side: Liquidity = options. Once you've put that extra money towards your principal, it's not easy to get it back. (You can apply for a home equity line of credit but this comes with fees). If you or your partner are unhappy with your job, you may need a buffer in the event you're laid off or decide to quit. If you anticipate you may need to help family members such as children or aging parents, it's best to keep this money in brokerage where it's accessed much easier.

This is why you have to first set aside enough money for your Emergency Fund (3-6 months savings) and Retirement Fund (15%+ per year) before considering the mortgage.

If this decision seems to daunting and this article is clear as mud. It may be time to set an appointment with a Financial Planner :)

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