Don’t Rush To Pay Down That Mortgage

The current mortgage rates are as good as they are going to be for a couple of years now. The current mortgage rate is 5 percent- a rate so good that it has forced people to rethink over paying off extra payments to pay off their debts well before their loan period is over. The Federal Reserve announced its decision not to buy mortgage-backed securities from now on last week. The rates are expected to go up once the Federal Reserve stops buying.

Your browser may not support display of this image. When rates used to be much higher at about 7 to 8 percent, it made sense to pay off extra payment to guarantee a return on your money. However, with the mortgage rate dipping low, it would be wise to invest your mortgage payments in someplace else where you can earn a greater return on your investment, especially when getting rid of your debt costs you much less.

Would you prefer to keep your money in a more liquid option than a mortgage? Having hit the lowest possible mortgage rates in years, would you be willing to invest your extra money in savings rather than clearing off your debt earlier than the mortgage requires.

The bottom line is this: Don’t make extra mortgage payments until you have cleared higher-interest debts. Speaking of higher-interest debt, credit card debt first comes to mind. Also, if you are not saving enough to get a full cover on your employer’s 401(K) or similar account, don’t rush to pay off the mortgage loans first. Increase your savings in that area first. Ensure that you have a decent emergency fund set aside before paying off the mortgage loans.

In reality, your interest rate is even lower than the 5 percent interest rate that you have. You get a part of your interest back each year in the form of a tax deduction. Picture this: Suppose your yearly income is $175,000. You pay 35 percent of it in taxes. If you pay $20,000 on mortgage interest each year on a 5 percent loan, that effectively brings down your yearly total taxable income to $155,000. That means that your total taxable income is lowered by a sum of $20,000. This in turn implies that you shall have to pay $7,000 (35 percent of $20,000) less in taxes per year.

This means that effectively, the after tax interest on your loan is brought down to 3.25 percent. So, any money that you have set aside for paying off the mortgage payments need to bring in a return of more than 3.25 percent. Seems quite feasible in current market situation, doesn’t it?

If you are worried that income taxes would cost you on the amount of money saved by not paying off the mortgage payments, all you have to do is to deposit the money into an account protected from taxes. A health savings account, a 529 college savings account, a Roth individual retirement account- all these would do the trick here. It is best advised to invest your money in some kind of tax-free investment. Otherwise, you may end up spending the money that you saved for paying off those mortgage loans.

The long-term rates for capital-gains taxes can well rise above the current rate of 15 percent. It is safe to have some of your savings in a taxable account though. In case you hit a long stretch of unemployment, banks won’t be willing to loan you money for a home equity loan without a steady income to repay it with. In case you need to sell your home and move quickly to a new town, why waste away extra amount of money on mortgage loan which you could have otherwise used as down payment for your new house.

Having said all this, one thing must be kept in mind. There is always a human factor involved when it comes to paying off the mortgage loan early. Many people want to ensure a good night’s sleep by repaying all their debts as soon as they can. This factor comes to play more strongly with people who are on the verge of retirement- many among them wish to retire without having a debt to their names. Many financial planners have taken this fact into consideration and helped their customers likewise. As one head of a major financial institution puts it- “The whole point of planning is to make life better,” he said. “It’s not to have more dollars at the end of the day.”

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9 Responses

  1. Guy G. says:

    Hey,

    This is exactly the detailed explanation I’ve been looking for to help clients understand that paying off debts is important, but the mortgage is ‘cheap’ money. Robert T. Kyiosaki of the book Rich Dad Poor Dad still has a mortgage because he can use the money from his equity as leverage to invest in business.

    Also, as far as tips on budgeting are concerned, it’s far more important to focus on eliminating high interest or any revolving debts.

    The only risk I see with not accelerating the mortgages now, is that I don’t think it will be too long before the rates are high again. Here in Canada, they’re already raising the rates, or at least planning on it.

    Thanks for the post,
    .-= Guy G.´s last blog ..The Mind/Money Equation – Tips on Budgeting =-.

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