If you ask yourself whether you should pay off the mortgage before you retire, your first impulse may be to say: "Why not?" Many people have an instinctive desire to own the house free and clear before they stop working, figuring the absence of a monthly mortgage payment will help relieve the pressure of living on a reduced income.
But prepaying your mortgage may not be the savviest move, particularly from a tax standpoint. This is especially true when faced with the choice between fully funding a tax-deferred 401(k) or adding to your mortgage payment each month. It even applies when the alternative is to invest more in a taxable account.
The reasons to channel the money into retirement savings are clear. Every dollar you sock away in a 401(k), individual retirement account, or other tax-deferred plan saves taxes now and lets your money grow tax-free over the long term. Taxes come due only when you withdraw, usually when your income and tax rate are lower.
Take the case of a 50-year-old couple in the 33% marginal tax bracket who want to retire in 10 years. They have $400,000 left on their 30-year, 6% mortgage, and each is eligible to contribute $20,500 a year to their 401(k)s. Karen Folk, a financial planner in Urbana, Ill., calculated the impact of putting $41,000 a year into their 401(k)s vs. diverting it to pay the mortgage.
In the first scenario, the couple maxes out the 401(k)s. After 10 years, even earning a modest 6% return, the two accounts would accumulate $559,922. With an 8% return, the accounts would gain about $625,066. That's more than enough, even after taxes, to pay off the remaining mortgage debt of about $175,000. In addition, the couple would have saved nearly $200,000 in taxes--$59,000 from the mortgage interest deduction and a deferred amount of more than $135,000 because of the 401(k) contributions.
Alternatively, if they put the entire $20,500 each into prepayments, the mortgage would be paid off in less than six years, leaving them just four years to pay the full $41,000 into their 401(k). Under this scenario, they end up with a paid-off mortgage and $385,000, if the 401(k) return is 6%; $402,000, if the return is 8%. Tax savings from the mortgage interest deduction and the deferred 401(k) contributions come to about $81,000, less than half that saved by putting all the money into 401(k)s.
Even if you're already maxing out retirement account contributions, investing extra money in a taxable account may be smarter. After JPaul Dixon, 38, a vice-president at insurance broker Hylant Group in Ann Arbor, Mich., made a $110,000 profit on the sale of his home, he thought he could put more money into a new $435,000 house and therefore pay it off sooner. But his adviser showed Dixon that he'd benefit more by putting only 20% down and investing the $110,000. At an annual return of 8% over 20 years, Dixon would end up with $512,705, more than enough to pay off the balance on the $348,000 mortgage he just took on.
You should also keep the mortgage if a big chunk of your payment is tax- deductible interest. Frank Moore, Dixon's financial planner, says the aftertax cost of a 6% mortgage is about 4% for taxpayers in the 33% bracket. If you can earn more than 4% after tax, you're better off not prepaying the mortgage.
Of course, if you don't think you'll have the discipline to invest the money, or if you're close to the end of the mortgage anyway and the tax benefits have dwindled, you just might pay it off. And don't discount the emotional aspect of your decision, says J. Steven Cowen, a financial planner in La Jolla, Calif. Knowing that his own business could face a downturn at any time, Cowen and his wife decided to kick in an additional $1,000 a month to mortgage payments. Their desire to stay in their house for the rest of their lives was reason enough.
By Ellen Hoffman