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Paying off your mortgage early... Good idea, or bad?
Introduction
Have you ever considered paying off your home early? Pay $20, $50, $100, $200 extra per month on your mortgage and you can own your home a lot earlier than the 30 years the bank expects you to keep paying them. However, what if your tax preparer tells you that you should not pay it off early because it will hurt your tax position, or cause you to pay more tax? Is it better to keep your mortgage and pay less tax? Will you pay less tax? How much money are we talking about? Is there a way you can save more money? This article addresses these question.
There are a lot of moving parts to the equation so first we have to discuss what a mortgage is.
How does having a mortgage help you?
The first and most important thing to recognize is that a mortgage (a loan secured by real estate) is almost always neccessary to purchase a personal home. The average person does not have the available cash to buy their home so they get a loan from a bank and in exchange they pay the bank interest on that loan. Each year their payment (which generally does not change) is applied more towards principle and less towards interest, this is called amortization (example of an amortization schedule below). So one benefit of purchasing real estate using financing (a mortgage) is that it allows you to actually purchase a home.
Since the inception of the tax code some form of interest has been deductible, there is no difference here. Home mortgage interest, which is reported to you at the end of the year on a form 1098 (sent to you by your mortgage company) is deductible on your Schedule A. This is one way that politicians stimulate the the real estate market, by offering tax incentives to people who purchase homes using financing (a mortgage). So the second way that a mortgage helps you is that it can provide a tax benefits. Or does it?
Next we need to see how the Home Mortgage Interest Deduction works.
How does the Home Mortgage Interest Deduction work?
The home mortgage interest deduction is available to people who have paid mortgage interest on their primary or second home (and you can claim both if you have both). In the amortization schedule above you will see that the interest paid for the first year on $150,000 loan at 5.25% with a 30 year term is $7,825. This amount is 'deducted' on your Schedule A, known to many as the long form. The Schedule A is a long list of deductible items that is used in place of the 'standard deduction' if it is higher.
Is that all confusing or what? Basically, everyone gets a standard deduction, a set amount of money that they do not have to pay tax on. This is determined by your filing status (Single, Married, Head of Household, ect). If all of the deductible items on your Schedule A add up to more than your standard deduction amount then you get to take the higher amount.
Example: James and Diane, a married couple, are filing their tax return together (Married Filing Jointly). Together they made $75,000, and paid all of the standard taxes on their wages. They had no children or other deductions. They have the mortgage referenced above $150,000 loan at 5.25% with a 30 year term. This is the first year of their loan so they get to deduct the $7,825 on their Schedule A. Their standard deduction is 12,400 (2009 MFJ amount). Their Schedule A has the following deductible amounts on it. Property Taxes $1,875, Sales Tax 1,009 (automatic), Vehicle Tags $300, Mortgage Interest $7,825 for a total of $11,009. The standard deduction will be used in place of the Schedule A total.
The example above is a relatively normal case. The home mortgage interest deduction does not even help the taxpayer. However, lets assume that everything else is the same exept that they have a $300,000 mortgage, which would have a first year interest of $15,649. If this were the case their Schedule A deductions would add up to 18,833 and they would get to use that number instead.
The standard deduction is removed from the 'Adjusted Gross Income' (along with the exemptions) to arrive at the 'taxable income'. The IRS uses the taxable income to calculate your tax by multiplying it by a percentage, or in most cases by using a tax table that takes into account tax percentages at several different income levels. Now that we know how and when mortgage interest helps the taxpayer we need to examine how much it helps them.
How much does the Home Mortgage Interest Deduction save you?
In the first example where James and Diane use their standard deduction (no mortgage interest), instead of their Schedule A deductions, their taxable income is $55,300, and their total tax for the year is $7,464 (13.4%). When we use the Schedule A deduction their taxable income is $48,867 and their tax due is $6,496 (13.3%). Essentially, by having a $300,000 mortgage and making monthly payments of $1,660, plus property taxes and insurance, James and Diane have saved a whopping $968 in tax.
Note:Home ownership is a good thing. You can build equity, do more with your property than property you are renting, and have pride in it. This article is in no way designed to disaude anyone from buying a home.
Why this question commonly comes up?
I am sad to say that tax preparers and accountants sometimes have a very limited perspective of things and give advice based on that perspective. Accountants and tax preparers have a lot of clients that they only see once a year at tax time. Their job is to prepare the clients tax return and not neccessarily to help the clients with their personal finances. So many accountants and tax preparers give advice based on strategies that would lower the clients taxable income and therefore lower their tax. In the case of the Home Mortgage Interest Deduction, advice to keep a mortgage to maximize the tax deductions associated with the mortgage can end up costing a client a lot more money than they would have paid in tax.
Any accountant or tax preparer that gives the advice to keep a mortgage, rather than pay it off early has not studied the issue, only cares about lowering the clients tax due, is incompitent, or is an idiot. In most cases they just have not studied the issue enough to see all the different aspects. Above we discussed how the Home Mortgage Interest Deduction provided very little tax benefit, but the bigger quesiton is what does gaining that benefit actually cost you? After all, if you were going to buy a house anyway, saving an extra $968 in tax is still a benefit right?
The lifetime cash perspective
The main question is not 'how much tax we can save', but 'how much money we can save overall'. The lifetime cash perspective is about looking at ways to reduce overall financial waste, or maximizing the amount of money that we can keep in your lifetime. There will be an entirely different article on this topic, but in this specific case it relates to the amount of interest you pay on the life of your mortgage as opposed to the tax benefits you derive from the interest paid. Finance charges(interest on a loan) are something you can affect. In the case of a mortgage you can pay extra on your mortgage and save interest. This is an example of using the lifetime cash persepective to reduce interest waste.
The idea of paying an extra amount of money on your mortgage to pay it off sooner is a great idea. In fact, if you pay an extra $100 per month on your $150,000 mortgage (5.25%, 30 year term) you will pay your mortgage off 6.5 years early. Even better, when referring to mortgages, time is money... By paying $100 extra per month you will save $37,200 in interest. Yes, it is true. Since interest is calculated based on the balance of the loan, when you pay the loan down more than you have to, the amount of total interest you pay also goes down. Saving you a bundle of money in the process. In this scenario you have to pay an extra $1,200 per year for 23.5 years, which is $28,200. Subtract that from the $37,200 of interest you saved and you have gained $9,000. That is a savings of 382.98 per year, or a 32% return on your extra $1,200 per year.
If you can come up with an extra amount of money to pay on your mortgage monthly you can save a lot of money over your lifetime, but how does that compare to the amount of money you could have saved on your taxes.
When the tax savings stops
Saving $968 in tax annually surely seems easier than writing a check for an extra $100 each month on your mortgage. You don't have to do any extra work, and it all comes out in the wash on your tax return. After all, savings is savings, right? Wrong, you saw how in the example that the couple that makes $75,000 per year and has a $150,000 mortgage does not even get any tax benefit. There are a lot of cases that do get a benefit from this deduction but the extra $968 in savings is at the cost of a lot more money.
You cannot maintain the $968 extra tax benefit for the life of the loan because each year you pay on the loan, you pay less interest and more principle. In the example of the couple that has the $300,000 mortgage their tax benefit stops after year year 17 and every year from 1 to 17 the tax benefit gets lower and lower. The lower the amount of the mortgage the faster this happens.
The bottom line
Paying off your mortgage early by making extra payments will be better than the tax savings you 'might' derive in just about every case. This is a long term strategy that will save you 10's of thousands of dollars in the long run. Anyone who give you advice to the contrary without providing mathmatical evidence is generally giving you bad advice.
Some Notes:
All of the figures presented in this article relate to specific examples. While the principles are all correct, the actual number presented may not relate to your specific situation.
If you are one of those lucky people who has enough money to buy a home with cash, or have enough money in the bank to pay off you existing mortgage... you generally should do it. It never hurts to meet with your CPA about it first.
If you are interested in how the principles above can affect your investment real estate please read my Long Term Real Estate Investment Analysis