Good question! And, a common one, too. When you have some extra money is it wise
to pay down the mortgage or is an investment a better choice. Let's begin by
understanding the mortgage interest deduction and then work on a framework for
Interest paid on a mortgage for your home is generally deductible on your
federal income taxes. To use the mortgage deduction you must file an itemized
1040, be legally liable for the loan, and the debt is 'secured' by the home.
The IRS defines home mortgage interest this way in publication 936: "any
interest you pay on a loan secured by your home (main home or a second home).
The loan may be a mortgage to buy your home, a second mortgage, a line of
credit, or a home equity loan."
There are some limits to the mortgage deduction. We won't get into the formula
here, but in most cases it won't be a problem as long as the money borrowed was
used to buy or improve your home.
The biggest problem with the mortgage deduction is that many people use the
standard deduction. In 2004 it was $4,850 if you were single or married filing
separately. Filing married on a joint return? You got $9,700.
The rules for what's eligible for deductions are beyond the scope of this
article. The safest way to figure out your status is to see what you did on last
year's and expect to do on next year's tax returns. The biggest items are
typically state/local income taxes, property taxes, medical costs and charitable
contributions. Before making any decision, see how your specific tax situation
would play out.
One way to look at the mortgage interest deduction is that you're paying someone
$1 in interest to get 25 cents back in tax savings. That's what would happen if
Julie were in the 25% tax bracket. I suspect that most of us would be willing to
give Julie a quarter for every dollar that she gave us. The point is that the
interest deduction by itself probably isn't a good reason to have a home
Now for Julie's choice. Can she get a better return by putting $30,000 into
paying off her mortgage or by investing it for her retirement. We'll need to do
a little math so hang on tight! And, we're going to simplify just a little. But,
that's ok. This decision doesn't require three decimal places.
What does Julie's mortgage really cost her? If her mortgage were 6% and her tax
rate were 25% she'd pay $1,800 interest during the year (.06 x $30,000). But,
that $1,800 in interest would be worth $450 reduction in taxes if she itemized
($1,800 x .25 tax rate). So the true cost of borrowing the money is really
$1,350 ($1,800 - $450). That works out to an interest rate of 4.5% ($1,350 /
Everybody still with me? Ok, next Julie can calculate what she'd earn by
investing the money elsewhere. If Julie were to invest the money, she'd earn the
investment return minus the tax rate.
Julie could invest in a lot of different things. And, they have different
potential rates of risk and return. We won't get into that today. Let's simply
assume that Julie found an investment that she thinks will earn 7%. In the first
year she'd earn 7% minus the amount paid in taxes. So she'd see $2,100 ($30,000
x .07) minus $525 ($2,100 x .25) or $1,575. Or a rate of 5.25% ($1,575 /
In this particular case, Julie mentions investing for her retirement. If she's
able to use a tax sheltered account, it's possible that she won't have to pay
taxes on the investment earnings for years.
So given these assumptions the investment looks better. Remember though that
predicting future investment returns, tax rates and the ability to use mortgage
interest deductibility aren't precise.
Julie also needs to be aware of any biases that her investment advisers have.
We're not saying anyone is dishonest, but it is easier for mortgage and
investment advisers to see the benefits of taking out a mortgage and investing
the money in other places. Julie shouldn't ignore what they say, but she should
be aware of the context of the advice.
Finally, there's an emotional side to be considered. Some people feel more
comfortable without debt. They sleep well knowing that no one can take their
home. Others have a more adventuresome nature and like the thought of picking
investments and earning a higher return.
If Julie takes the time to work through her choices and how she feels about
them, she's likely to make a decision that she won't regret later.
Gary Foreman is a former financial planner who currently edits
The Dollar Stretcher.com website and
newsletters. If you'd like to save time or money, you'll find thousands of
articles to help you stretch your day and your dollar. Visit Today!