I’ve long argued that people can earn a risk-free, 3 to 6 percent annual return on investment by paying down their mortgage. The new tax overhaul means you now may be able to get this return tax-free as well. That’s because you may no longer be getting a tax deduction for part or all of your mortgage interest.
It's important to understand that a mortgage is basically the opposite of a bond. When buying a bond or bond fund, you are lending money to corporations or governments that, in turn, pay you interest and your principal back, unless there is a default. When taking out a mortgage, you are paying a bank or other party principal and interest, which must be paid back irrespective of whether your house appreciates.
Let's take an example of a consumer with a $100,000 mortgage at a 4 percent annual interest rate, who also is in the 30 percent marginal tax bracket (combined federal and state). She could invest in high-quality bonds or a five-year CD, both yielding about 2.45 percent annually. By doing so, she would earn $2,450 before taxes and $1,715 after taxes.
If instead of buying the CD, she pays off her mortgage, she would save roughly $4,000 in interest payments. Under the old law, she would likely have received a tax deduction worth $1,200 (30 percent of the mortgage interest), so she would have saved $2,800 after taxes. This consumer would have been better off by $1,085 a year by paying down the mortgage, because saving $2,800 is better than earning $1,715.
Under the new tax law, this person is less likely to benefit from the mortgage tax deduction. Mike Piper, author of Taxes Made Simple, says that many people who used to itemize are less likely to do so now because of the larger standard deduction, the $10,000 limitation for state and local taxes, the elimination of miscellaneous itemized deductions, and the fact that some home-equity related debt will no longer be deductible.
Under the new law, you are far less likely to itemize because a very large mortgage deduction may now be gone, combined with the fact that you likely will need more itemized deductions in total just to reach the higher standard deduction. According to the New York Times, the D.C.-based Tax Policy Center estimates that only 20 million Americans will itemize in 2018, compared with 46 million, had the tax law not changed.
Using the example above, where one does not get a deduction for mortgage interest, one would save $4,000 after taxes — which is a heck of a lot better than earning the $1,175 after taxes from the CD or bond fund. Now even if you do itemize in 2018, you may only be getting a deduction for part of your mortgage interest. As an example, if you are married filing jointly and have $22,500 of itemized deductions before the mortgage interest, only $2,500 of interest benefits you, as the first $1,500 only gets you to that new $24,000 standard deduction amount. Check with your tax adviser to see if you will receive a tax benefit from all of your mortgage interest paid.
Here are three of the most common counterarguments I regularly hear — that I just don't buy — about paying down your mortgage:
- A more balanced portfolio of, say, 60 percent stocks and 40 percent bonds can earn more than what you would gain by paying down your mortgage. Though this may be true, it is more a case of comparing apples to oranges. This argument is analogous to taking out a margin loan on your brokerage account to buy more stocks. You might earn more if your stocks go up, but I would not recommend it, even though margin loans are often at lower rates than mortgages. Also, I've heard this argument for decades and, so far this century, bonds have outperformed stocks. Borrowing to buy more stocks has backfired.
- You don't want to put more money into the house. I'm not suggesting putting more money into the house, such as a house remodel. Paying down the mortgage has no impact on the price for which you ultimately sell your house.
- If you don't fully pay off your mortgage, your monthly payment will not decline. This statement is true, but it's not the full picture. Because a much greater proportion of the monthly payment is going toward principal as you pay down your mortgage, the mortgage is paid off much sooner and you still save the interest payments.
One extremely valid argument for not paying down the mortgage, if you have the money to do so, is that you may need the cash to live on for emergencies. Once you put the money toward the mortgage, it's not so simple to get that cash back again.
After the mortgage is fully paid off, and if you still have income, I recommend making monthly deposits in the amount of the mortgage payments to a savings or investment account.
In deciding whether this advice is right for you, keep two things in mind:
- Banks, brokerage firms and financial advisers typically do not benefit from this advice. Banks want you to keep paying them monthly interest on your mortgage. Brokerages and financial advisers usually would rather have you invest the money that you would use to pay off your mortgage with them.
- Think about it: Have you ever met anyone who regretted paying off their mortgage?
So if you have enough liquid assets to feel comfortable and can earn a risk-free and tax-free return by paying it down, consider it low-hanging fruit ripe for the picking.