Paying off your mortgage could be a good idea

John W. Schoen Senior producer • Profile • E-mail

With foreclosures on the rise and mortgage companies swamped with calls from distressed borrowers, who wouldn’t want to be out from under the biggest loan of their lifetime if they afford to?

Is it a good idea to pay off my mortgage early?
— Mary A, Pennsylvania

It’s hard to put a value on the feeling of being mortgage-free. But before you scrape together every nickel you’ve got to get the mortgage monkey off your back, you’ve got to do some math.

First step: Pay off higher-cost debts first.  It makes no sense to divert your savings to a mortgage costing you 6 percent if you’ve got a significant credit card balance at 18 percent.

The next question is whether the money you’ve got set aside is earning more than your mortgage is costing you — after taxes. Here comes some math:

Let’s say you’ve got a $50,000 mortgage balance that’s costing you 6 percent interest. If you’ve got $50,000 stashed in low-risk savings like CDs or Treasury bonds, you’re probably earning about half that at best — let’s say 3 percent.  So far, you’re better off paying off the loan.

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Now factor in the tax impact. If you’re in the 25 percent tax bracket, the after-tax return on your savings drops to 2.25 percent. Your after-tax mortgage cost is also cut because you can deduct the interest expense from your tax bill — if you itemize your deductions. For homeowners, mortgage interest and state and local taxes are usually the biggest deductions.

But only about a third of taxpayers itemize, according to the IRS. So if your total deductions aren’t more than the standard deduction ($11,400 for married couples filing jointly;  $5,700 for singles and married people filing separately, and $8,350 for heads of household), your mortgage isn’t creating any tax savings.

Even if you do itemize, if you’re in the latter years of paying off your mortgage, your deduction is shrinking. That’s because, early on, mortgages are almost pure interest, gradually shifting to pure principal by the end of the loan. Only the interest portion of your mortgage is deductible.

That means to beat your 6 percent mortgage cost, you’ll have to generate an 8 percent return on your investments, year-in, year-out. Even if you put everything you have in stocks, the average historical return is closer to 7 percent. And there’s no guarantee that the financial markets are going back to that historic norm anytime soon.

For retirees — or near retirees — putting everything is stocks is a pretty risky strategy. So when you add it all up, it usually makes sense for older homeowners to pay off their mortgage, according to a recent paper from the Center for Retirement Research.  This assumes you have enough left over to retire on; if not, you’ll be right back to borrowing against your house to pay expenses. If you don’t have a big enough nest egg, you maybe better off selling the house, buying a smaller one with cash, and retiring on the difference.

Paying off a mortgage may make less sense for younger homeowners, for several reasons. First, they should have as much of their savings as they can in tax-advantaged accounts like an IRA or 401(k) — and raiding those to pay down a mortgage comes with hefty penalties.  Younger homeowners are also more likely to be in the early years of their payment schedule when the interest deduction is bigger. And they may be better-suited to riskier investments.

But the only way to decide is to do the math.

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