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Mortgages: To Pay Off or Not to Pay Off

Posted: Mateo Salmeron

If you got a mortgage or had the chance to refinance in the last 10 years, congratulations! You were able to lock-in historically low rates for your house payment. A question we often get is if someone should pay off their mortgage and what other options they could explore. Jonathan recently spoke on this topic in March addressing what factors homeowners should consider emotionally and mathematically.

On the emotional side, mortgage payments can play a major part in monthly expenses. Borrowers will sometimes say they are a “slave to the lender” and have a strong desire to rid themselves of the major debt from a mortgage. On the mathematical side, if your mortgage rate is less than your investment return then investing in the market would be more to your benefit. There are many more factors at play when it comes to comparing the two numbers that we’ll be outlining.

Investing instead of prepaying a mortgage is the equivalent of investing with leverage. Investments should create a risk premium depending on the level of risk taken. Risk premium is the investment return an asset should earn in excess of the risk-free rate of return in order to justify its given level of risk. The risk-free rate is the rate of return of an investment with no risk. A US Treasury is commonly used as the risk-free rate.

In a homeowner’s case, the risk-free rate should be the borrower’s mortgage rate since they are always guaranteed to owe the bank that interest amount and not guaranteed what they’ll earn in the market. Mortgage rates from 2010-2021 were at their lowest ever, meaning it was not best to not pay off your mortgage because of the potential higher risk premium you could potentially earn with investing. Today, mortgage rates have jumped due to the Fed combating inflation. Therefore, investing has a much higher hurdle rate to justify investing versus just paying off a mortgage. In other words, if you locked in a mortgage rate within the last several months, it may make more sense to just pay it off early.

If that difference in risk premium is not as important to you, then the tax savings associated with your mortgage is another bucket to consider. A taxpayer can deduct interest on the first $750,000 of mortgage loan amount if they are able to itemize their deductions on their tax return. The tax savings part of your mortgage payment is the dollars from your interest coming back to you at your marginal tax rate. That savings amount can indirectly lead to a higher contribution to investments/savings for retirement. This opportunity is missed if you are only able to take the standard deduction and don’t get to apply the savings from your mortgage interest to investments.

Besides the tax savings and investment potential side, there might be other factors to consider before deciding to pay off your home. A question you can ask yourself to decide which path is right for you is, “If your home was already paid off, would you borrow from it to invest?”. And if the answer is no, then paying off the home now might be more worth it.

At the end of the day, not everyone’s situation is the same. We would be more than happy to help evaluate your situation to ensure what options help provide for a successful financial plan.

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