Financial Problem Solved! "Should I pay off my mortgage?"

July 11, 2003

The right choice depends on several personal factors.

 

FINANCIAL PROBLEM SOLVED!

"Should I pay off my mortgage?"

Problem

I owe $50,000 of principal and have 10 years to go on my mortgage. I also recently inherited about $50,000. How do I decide whether to pay off my mortgage or invest the money?

Solution

The right choice depends on several personal factors. You might retire the mortgage if you value the security of a paid-off home, you'd rather not invest in an uncertain stock market, you want to lower the total cost of your mortgage, or you can't deduct 100 percent of your interest because your adjusted gross income is over $139,500. But to leverage your home's equity, make more money as the stock market rises, and maximize your interest deductions, you're better off keeping the mortgage.

Since no one knows whether the stock market will be up, down, or flat in coming years, your main criterion should be your risk tolerance. If you can't bear to lose any capital, your tolerance is extremely low. In that case, pay down the mortgage. If you can accept some risk and think you can do better by investing, consider going that route.

What do you believe the market will do over the next 10 years—the time remaining on your mortgage? Expecting average returns of 15 or 20 percent annually isn't realistic. If you're risk-averse, a return of about 6 or 7 percent annually over the long term may be a reasonable assumption; if you're more aggressive you might use 10 percent.

Your current and future tax brackets also play an important role in your decision. Let's assume you have short-term investment gains, on which you pay ordinary income tax. If you're in the 35 percent marginal tax bracket, a 7 percent taxable return is then equivalent to a 4.6 percent after-tax return; a 10 percent taxable return is equivalent to 6.5 percent after taxes. Comparing your after-tax investment return with your mortgage rate can help you decide which strategy makes the most sense.

Another option: Consider paying off the mortgage and then investing the monthly principal and interest you save. Let's compare that with simply investing the $50,000 lump sum. In both cases, we'll assume you get a 4 percent after-tax return. In example A (paying off the mortgage), after 10 years you'd end up with $98,291. In example B you'd have only $74,541.

What if the market returns 9 percent after taxes? Then investing the $50,000 up front would earn you $7,142 less than paying off the principal and investing the monthly savings. The crossover point is 11 percent, after taxes; then you'd do better by putting the entire $50,000 into the market than you would by paying off the mortgage. In the above scenarios, I've done the calculations using assumptions specific to your situation; the numbers may differ slightly for other people.

The number of years remaining on your mortgage is a key factor. If you had 20 years left, the figures would be different; then it wouldn't take such high returns to make investing the lump sum the more attractive alternative. Ultimately, you must do what makes you most comfortable. Only in retrospect will you know whether your choice was the most profitable one.

This issue's problem solver is J.A. Abels, CFP (j@familyestateplanning.com), a financial adviser with Family Estate Planning, in Omaha. Financial Problem Solved! is edited by Senior Editor Leslie Kane.

 

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Leslie Kane. Financial Problem Solved! "Should I pay off my mortgage?". Medical Economics Jul. 11, 2003;80:69.