Should I Pay Off The Mortgage Or Invest In The Market?
A reader e-mailed me this week to ask if they should pay off their mortgage or invest in their 401(k) for retirement. There are a lot of things to consider when making this decision, so there is not a single right answer for everyone. Here are a couple of questions I would recommend asking yourself when deciding between debt pay off and saving for the future.
“Do I have an emergency fund?”
If the answer is “Yes” then move to the next point. If the answer is “No” then I would strongly advise putting any extra money that you can towards building an emergency fund with 3-6 months of living expenses.
“What is my mortgage interest rate?”
If your mortgage rate is at 6% and you pay it off, you have gotten a guaranteed rate of return of 6%. This means you would need to get at least 6% in the market in order for investing to make sense, and really it needs to be a lot more to make up for the risk of the market versus the guarantee of paying down debt. If your mortgage is at 2.75%, it may not be quite as clear cut of a decision as if you are at 6%.
“What is my tax rate?”
Since mortgage interest is tax deductible, a 6% mortgage isn’t actually 6%. If you are in the 35% tax bracket, then a 6% mortgage actually costs you about 3.9%. To get your actual mortgage interest rate, use the following calculation: Interest Rate * (1 – tax rate). For instance, the above example would be: .06*(1-.35) = .039 or 3.9%
“Do I itemize my deductions?”
According to a 2005 study, only 54% of Americans paying mortgage interest actually get a tax benefit. This is because you can only deduct your mortgage interest if you are itemizing your deductions. Take a look at last year’s tax return to see if you even itemized. If you did, how much more were your itemized deductions than the standard deduction? If this isn’t a large number, then the above question of “What is my tax rate?” will be irrelevant.
“Would I take out a loan to buy stocks?”
When I ask clients this question, they always respond with NO! What if the interest rate to take out the loan was 5%? How about 3%? I can never get one to take me up on it. This is actually no different than choosing to save instead of paying down the mortgage! If you have $100 and decide to invest instead of paying down your mortgage, you are especially borrowing money to invest in the market. If you wouldn’t do this directly, why would you do this indirectly?
So what is the answer? As always, the answer is IT DEPENDS! Beyond the numbers, there is a huge psychological benefit to being debt free. I have never had a client pay off their mortgage and later regret it. I do believe though that you have to find a balance between paying down debt and saving for the future. If you have an emergency fund, I usually recommend at least fully utilizing your employer match on your 401(k), and then pay down debt as much as possible. Most clients chose a combination of debt payoff and savings, which is typically a good path to take.
So what do you think? Are you trying to decide between debt pay off and savings? Have you paid off your mortgage and have advice for other readers? Feel free to share!
Alan Moore is a fee-only financial planner and founder of Serenity Financial Consulting in Shorewood WI. Follow him on Twitter @R_Alan_Moore. You can contact him at alan@serenityfc.com, 414-455-5313, or visit his website at www.SerenityFC.com. Want more education? Download your free guide to the “10 Easy Steps To Securing Your Financial Future Today.”
H.E. Pennypacker
10:55 am on Thursday, October 18, 2012
All debt is bad debt. Mortgage debt is bad debt, look at the amount of interest you are paying over the life of the loan, regardless of any tax benefits, it will make you sick. Pay off your home and be free, don't be a debt zombie.
Craig
11:01 am on Thursday, October 18, 2012
Never borrow money to invest in the market, even if the rate is 0% or 1%.
Even at 0%, the markey could take a dump leaving you with a repayment for something that has vanished.
Randy1949
11:24 am on Thursday, October 18, 2012
After my mother-in-law passed away, we learned that her financial adviser had told her to take out a loan on her life insurance policy to invest 'elsewhere' presumably in mutual funds. The resulting loan interest had eaten almost the entire remaining death benefit over and above the original loan amount. I'm not sure what rate of return those mutual funds would have had to have earned to break even, but I don't think they did.
This adviser worked on commission.
Craig
11:39 am on Thursday, October 18, 2012
And life insurance proceeds are tax free! Bet you had to pay tax on the mutual funds?
This is predatory selling by advisers.
Randy1949
11:49 am on Thursday, October 18, 2012
As IRA beneficiaries, yes, we had to pay tax on the sale of those mutual funds, more than if they'd been regular mutual funds, which would only have been a capital gain over the cost basis.
I'll do that well-known brokerage institution a favor and not mention their name.
Alan Moore, MS, CFP®
11:50 am on Thursday, October 18, 2012
H.E. Pennypacker, I believe that debt is neither good nor bad... there is no morality to debt. It is how we USE debt that matters. That being said, you are correct that a lot of folks are surprised to learn how much they pay in mortgage interest.
Craig, do you think it is okay to borrow to start a business? Is there anytime you would use debt for an investment?
Randy, that is an incredibly sad case of an "advisor" gone rogue. I don't believe most would make these types of recommendations, but you do need to stay alert to what an advisor recommends.
Craig
12:13 pm on Thursday, October 18, 2012
Alan; Good question.
If you mean borrow from a lending institution to start a business, I am okay with that. Usually proper documentation is needed to show forecasted ability to repay.
To use debt to fund an investment is a different animal. I know of people who used a Credit Card offer of 0% for 12 months to fund an investment of $50,000 in Mutual funds.
Granted, people don't typically lose 100% of a mutual fund- but it is possible.
It is proven they could lose half, so let's assume that happened. After 12 months, where does the client get the funds to payoff that CC debt? Interest will be retroactive to day one.
I do not believe most professionals would do this, but there must me some out there who have.
I have heard of people using their old 401(k) plan as start up capital for a new business. The funds from the 401(k) buy shares of the sole proprietor's business, avoiding taxation as earnings. For a 40 year old, this could mean avoiding almost 50% tax. I believe the business owner forms a C corp.
If you are familiar with this strategy, I think an article about it would be wonderful.
Alan Moore, MS, CFP®
12:16 pm on Thursday, October 18, 2012
Craig, thanks for the thoughtful response. We all have a different tolerance for taking on debt. I know of some business owners that refuse to take on business debt while others have used it quite successfully (and other not so much).
I agree that using money on a credit card to invest in the market is VERY risky. I wouldn't recommend it due to the level of risk.
You are correct that money in 401(k)'s can be used to start a company using a C-corp but it is fairly complex and has to be approved by the IRS. I will try and write about it in the next couple of weeks.
Randy1949
12:22 pm on Thursday, October 18, 2012
There is an article I would like to request, and that would be one with advice about the financial and legal duties of the executor of a will -- appraisals of material assets etc. for the basis of that 'step-up' the heirs will have to pay taxes on.