This age old debate has been going on for quite some time now...
One side of the aisle believes getting rid of all debt is the only way to financial freedom. Quite simply, they just don't like owing other people money and there's nothing wrong with that.
On the other side of the aisle you have individuals who like to run deeper mathematical analysis. They find it foolish to prepay a long term debt of 3-4% when you can earn a historic average of at least 7% in the stock market. Couple that with the ability to deduct home mortgage interest from your federal taxes... it's an open and shut case! For this group it's simply about the numbers and that's ok too.
Remember, this is "personal" finance, you will often find what works for one individual or family doesn't work for another.
Take the time to analyze your own situation
For starters, take a look at what the home mortgage interest deduction really means for you!
Figure out your home mortgage interest deduction by looking at your effective tax rate. Say your overall tax rate is 25%, for example. On average, the home mortgage interest deduction reduces your taxes by $25 for every $100 you pay in mortgage interest.
Sounds good right? But there’s a caveat, your home mortgage interest deduction is only valid for the amount you deduct over and above the standard deduction, which is available to taxpayers who don’t itemize their returns. The standard deduction for married spouses filing jointly is $12,600 in 2016.
What does that mean? Unless you itemize your taxes, your home mortgage interest deduction is worth nothing. If you do itemize your taxes, then the deduction is only worth what it helps you save over the standard deduction that anyone can take. You have to do the math, but generally speaking, this deduction is only truly worth considering if you are in the higher income brackets.
But what about the opportunity loss of investing returns?
While certain individuals scoff at the idea of paying down low interest debt instead of investing their extra dollars in the stock market. We believe you have to look at it from multiple perspectives. The stock market has performed historically well, therefore the math favors those who choose to hold onto low-interest mortgages and invest their extra dollars instead. However, it's important to remember the stock market is not guaranteed, while the interest you save by paying off your mortgage early is a guarantee.
Instead of arguing who is “wrong” or “right,” we tend to ask people these questions...
- How far away from retirement are you?
- What will help you sleep better at night?
- How secure is your job?
These are some of the many questions that can help you during the decision making process to determine if paying off your mortgage early is right for you.
Determine if your home is your proverbial forever home
Calculate Loan Payoff Date & Total Interest Paid
You must have financial discipline and discretionary spending money
Let's Do The Math Behind It
So you've decided to allocate some or all of your monthly surplus in income towards your mortgage. Let's see if it makes sense financially...
TSP Portfolio Balance: $41,000
Mortgage Balance: $300,000 | 4% - 30 years
- $1,432 Mortgage Payment
- $215,608 Interest Paid Over Life of Loan
Monthly Surplus Towards Mortgage: $275
John can take out a TSP Loan for $3,300 ($275 x 12 months) at a lower rate than his current mortgage and pay that towards his principal all in one month or he can simply make extra payments of $275 on a monthly basis towards his mortgage.
TSP Loan vs. Monthly Payments
Interest & Fees: $83 vs. $0
Opportunity Loss In The Stock Market: $285 vs. $0
Interest Eliminated: $6,662 vs. $6,483
Loan Period Shortened: 6 months vs. 6 months
Based on these numbers it's clear to see taking a TSP Loan to pay down your mortgage is not the ideal strategy. Granted you save a couple extra hundred dollars in interest and shorten the life of the loan by 6 months, but is it really worth the hassle? Not to mention what you lose in interest/fees and opportunity loss in the stock market.
But what if we extended this tactic to 5 years instead of one. What if John took out a TSP Loan for $3,300 ever year and paid it towards his principal at the beginning of each year. Or, what if John made monthly payments of $275 for 5 years? Maybe the numbers would be different? Let's see...
Interest & Fees: $415 vs. $0
Opportunity Loss In The Stock Market: $1,425 vs. $0
Interest Eliminated: $27,743 vs. $26,983
Loan Period Shortened: 30 months vs. 30 months
One would think making more payments over time would skew the numbers but they don't. Generally speaking, it is quite clear using a TSP Loan to pay down your mortgage is not a great strategy. You are better off paying your monthly surplus of income towards the principal payment of your mortgage.
Here's to our wealth!