Financial FICTION #2: Aggressively paying off your mortgage debt is savvy and always beneficial to you, financially speaking.
Many people buy into this notion based solely on the fact that there is a cost associated with carrying a mortgage (in the form of interest payments) and the belief that by eliminating their mortgages, they therefore stand to save that money. There’s also an emotional connotation – paying off your mortgage feels good and even carries some wealth-related social status.
However, both reasons completely miss the underlying and central financial principle that should guide such decisions – Profitability and Opportunity Costs. Sure, there is an interest cost associated with carrying a mortgage, but there’s also a cost for paying it off, too. Proper and savvy financial management teaches that when it comes to such choices, you take the route that will cost you the least amount of money or make you the most money.
Let’s examine this principle with this hypothetical scenario involving the Greens, who have a 30-year $100,000 mortgage at a 6 percent APR. They are in a 30 percent combined (federal and state) marginal tax bracket. They recently inherited $100,000, which is currently earning a net after-tax return of 5 percent a year. The Greens are now trying to decide whether it would be beneficial for them to use the inheritance money to pay off their mortgage.
Here’s how the application of financial principle works: The $100,000 mortgage is costing them 6 percent. But since it is a deductible expense on their tax return, Uncle Sam gives them a 30 percent break, which shaves off 2 percent (0.30 multiplied by 0.06) from the 6 percent interest on their mortgage, meaning that in actuality, their mortgage is costing them only 4 percent. I’m sure one of the reasons most people are encouraged to purchase as opposed to renting is so that they may enjoy this very benefit, isn’t it?
One thing I’d like to particularly note here is that when figuring the net cost of your mortgage, it is imperative that you use your marginal tax rate, NOT the effective tax rate, because we have a progressive tax system in America.
OK, that aside, the Greens’ mortgage is costing them 4 percent, versus the 5 percent they could earn if they invested the money they’re considering using to eliminate the mortgage. It’s a no-brainer, right? But you’ve got to realize how we got here – we put aside the emotional stuff and got down to hard facts and numbers, which by the way is exactly how successful, savvy folks make these kinds of decisions.
Let’s examine this principle with this hypothetical scenario involving the Greens, who have a 30-year $100,000 mortgage at a 6 percent APR. They are in a 30 percent combined (federal and state) marginal tax bracket. They recently inherited $100,000, which is currently earning a net after-tax return of 5 percent a year. The Greens are now trying to decide whether it would be beneficial for them to use the inheritance money to pay off their mortgage.
Here’s how the application of financial principle works: The $100,000 mortgage is costing them 6 percent. But since it is a deductible expense on their tax return, Uncle Sam gives them a 30 percent break, which shaves off 2 percent (0.30 multiplied by 0.06) from the 6 percent interest on their mortgage, meaning that in actuality, their mortgage is costing them only 4 percent. I’m sure one of the reasons most people are encouraged to purchase as opposed to renting is so that they may enjoy this very benefit, isn’t it?
One thing I’d like to particularly note here is that when figuring the net cost of your mortgage, it is imperative that you use your marginal tax rate, NOT the effective tax rate, because we have a progressive tax system in America.
OK, that aside, the Greens’ mortgage is costing them 4 percent, versus the 5 percent they could earn if they invested the money they’re considering using to eliminate the mortgage. It’s a no-brainer, right? But you’ve got to realize how we got here – we put aside the emotional stuff and got down to hard facts and numbers, which by the way is exactly how successful, savvy folks make these kinds of decisions.
In August 2006, the Federal Reserve Bank of Chicago issued a 58-page report titled “The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings,” in which they concluded that most American homeowners are making the wrong choice by accelerating mortgage payments instead of putting the money into tax-deferred accounts. The report further stated that the misallocated funds cost U.S households as much as $1.5 billion every single year! I would recommend that every homeowner (and especially those financial professionals who hold the payoff-quickly point of view) take some time to review this eye-opening report.
If this is really true, why do all these TV and Internet gurus tell homeowners to pay-off their homes quickly? I wish I could answer that, but honestly I can’t, other than to say that maybe it sounds emotionally appealing. Just as it would be completely irresponsible for me to make a blanket statement that no one should pay off their mortgage, the opposite is also true, wouldn’t you agree?
That’s why I always recommend that you chat with a savvy, well-trained financial professional(s) who is loaded with a ton of common sense, so that you can decide YOUR Profitability and Opportunity Costs, considering all the details pertinent to your specific situation.
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Contact Laser Financial Group today to set up your completely complimentary (no-strings-attached) consultation with a financial professional who can help you determine whether paying off your mortgage quickly is really in your best interests. 301.949.4449 or LaserFG.com.
Contact Laser Financial Group today to set up your completely complimentary (no-strings-attached) consultation with a financial professional who can help you determine whether paying off your mortgage quickly is really in your best interests. 301.949.4449 or LaserFG.com.
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