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By John Spoto
In my article “Should you pay off your mortgage early?”, I discussed some of the key considerations in deciding whether or not to accelerate the paydown of your mortgage. Once you have cleared those basic hurdles, the next step is to compare the interest you are paying on your mortgage with the interest rate you are earning on a savings instrument like a certificate of deposit. I suggested that if your mortgage rate is higher, then consider redeploying some of your surplus savings and/or current income to pay it down. I purposely used the CD for the comparison and ignored the effect of taxes. Here’s why.
Using a higher-yielding investment instead of a CD. Some might propose that instead of a CD, they could earn a higher return if they invested in stocks. The flaw with this argument is that it doesn’t account for the substantial risk in the stock market. Paying off a mortgage loan is a risk-free proposition. You pay off your loan and you are left with your home. Invest in stocks, and you have no guaranteed return and worse, your principal could decline substantially.
The appropriate comparison to a mortgage is a safe investment such as a high-quality bond or a CD. With either of these, you loan out your money and you are guaranteed (assuming a U.S. Treasury bond or an FDIC-guaranteed CD) to get your principal back with interest. I used the CD as a comparison because most people are familiar with this product.
Homeowners, especially those in the higher income tax brackets, could argue that the tax deduction on interest is a compelling enough reason to keep the mortgage. This ignores the other half of the equation, which is the additional taxes paid on the interest earned on your savings. In other words, the tax savings from the mortgage interest deduction is offset by the additional taxes you pay on the CD income. One caveat is that the tax code is complicated so this might be an area to enlist the help of your tax preparer.
In his 2009 research brief on this subject from the Boston College Center for Retirement Research, author Anthony Webb concluded that “A household that chooses not to repay a mortgage is, in effect, choosing to finance the ownership of its financial assets with borrowed money. If the after-tax return on the household’s risk-free assets, such as bank certificates of deposit, Treasury bills, and Treasury bonds, exceeds the after-tax interest cost of the mortgage, the household has an opportunity to make a risk-free profit.”
A risk-free profit — now that’s an enticing proposition!
This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax, or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.