Should you pay off your mortgage, or not?

Good news! You have just had an unexpected windfall of $300,000, exactly the amount you still owe on your mortgage. Do you know what you would do? Would you rush to pay off your mortgage with your new-found cash, or would you keep your mortgage and invest the cash?

If you are lucky enough to have such a dilemma, no doubt you have realized there are both mathematical and psychological factors to consider in order to determine the best use of your money.

Advice on the subject varies widely. There are many variables involved and every situation is different. And yes, getting to an answer might require that you sit down with a financial advisor or tax advisor, someone who doesn't have any products to sell and thus can be objective, to look at your situation.

But don’t put off deciding what’s best to do; indecision alone can cheat you of peace of mind and economic opportunity.

THE QUESTION AND OUR ASSUMPTIONS
Let’s limit this discussion by comparing only two options: On the one hand, you can use the $300,000 to pay off your mortgage; on the other, you can invest the $300,000. Which is the better choice?

We’ll assume that you:

• have a 6 percent 30-year mortgage with a balance of $300,000;
• are in the 25% marginal tax bracket;
• have adequate cash flow so you can keep making the payments if you choose to do so;
• have enough itemized deductions to exceed the standard deduction;
• have an emergency cash reserve;
• have adequate retirement savings, and
• have no other compelling need for the cash.

THE MATH
Let’s start with what your mortgage really costs you. Interest of 6 percent on a $300,000 balance is $18,000 in one year. Because you deduct the interest, your taxable income goes down by $18,000. That cuts your taxes by $4,500. Your after-tax interest cost therefore is $13,500, or 4.5% of $300,000.

Now the question at hand: Should you keep the mortgage and invest the extra $300,000? The answer to that requires evaluating two scenarios.

SCENARIO 1: YOU PAY OFF THE MORTGAGE

What happens if you use the $300,000 windfall to pay off your mortgage?

You still have a house that’s appreciating (hopefully), but now you no longer have the debt. You don’t have more assets; in fact you actually have less because you’ve no longer got the $300,000 cash. But you have also decreased your liabilities by $300,000; so your net worth is the same.

What did you gain by doing this? Clearly you have eliminated your monthly mortgage payment. You have saved, after taxes, $13,500 in interest expense in one year.

Less obvious is that this scenario is the equivalent of putting $300,000 in a 6 percent savings account from which you cannot make a withdrawal until you either sell the property or get a new mortgage – which can be expensive, slow and inconvenient.

In other words, you have given up the liquidity on your $300,000.

If you wouldn’t put your money in a 6 percent savings account with these restrictions, you should consider whether paying off your mortgage is right for you.

SCENARIO 2: YOU KEEP THE MORTGAGE AND INVEST THE CASH

What happens if you keep the mortgage and invest your $300,000 windfall?

Assume that you invest in equities and earn a 10% return; you would gain $30,000 in one year. Using the long-term dividend and capital gains rate of 15 percent, if you sold the investments after one year, that would leave you with after-tax gains of $25,500. Compare that to the $13,500 you would save by eliminating your mortgage interest.

Let’s pause here for a moment because this is quite interesting. That difference of $12,000 came from two sources. One is the payoff we assume you received (never guaranteed) for taking investment risk. The second is the difference in tax rates that apply – 25 percent to your deductible interest vs. 15 percent to your dividends and capital gains.

But our assumed 100% allocation to equity funds is probably too risky in this situation. A 50/50 allocation between stocks and bonds is more likely to be appropriate.

Let’s say that you earn 8 percent return on a mix of equity and fixed-income funds. You gain $24,000 in one year. But now it becomes difficult to say exactly what your effective tax would be.

Why is this?

The applicable tax rates will depend on the types of investments you make, and when and if you sell them. It’s safe to say that, if you sell your investments after one year, some of your $24,000 in gains will be taxed at 15% and some at 25 percent. If the overall tax rate on these gains were 20 percent, that would leave you with $19,200 after tax; or $5,700 more than the $13,500 you would save by paying off the mortgage. That’s an improvement of nearly 50 percent.

Thus it can make financial sense to keep your mortgage and invest your cash – provided that you invest well and don’t exceed your own risk tolerance. None of the investment returns I mentioned is guaranteed. And this leads me to the other major set of questions you should ask yourself.

THE PSYCHOLOGY

You are not a machine; you have emotions.

You may want to override this mathematical analysis. If having a mortgage robs you of your peace of mind; or if you hate bankers with a passion; or if the idea of living debt-free really makes you feel better – then even the safest investment may not help you sleep at night.

In that case, go ahead. Buy yourself some peace of mind. Not all decisions should be made on the basis of the numbers involved.

SOME FINAL CONSIDERATIONS

Keep these two things in mind:

1. Assuming your home is going to appreciate, it will do so whether you have a mortgage or not. Paying off the mortgage won’t bring you any additional appreciation.

2. By investing in stocks and bonds, you have an opportunity to get appreciation that you otherwise wouldn’t have.

A HOME IS UNIQUE

At the end of your journey, no matter what the numbers say, a home is an investment unlike any other. Math is a good place to start, and a CPA or financial advisor can certainly help you sort through the math involved and apply it to your circumstances.

But it should be a combination of your heart, your brains and your gut that guides you in the end, not just the numbers.

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