A Message from Kimberly Clouse, Financial Expert:

I have worked in the financial services industry for nearly a decade in many capacities, most recently as a financial adviser for individuals. Over the course of my career, I have had the privilege of working with a diverse range of people, from the single mother just starting her own business to the dot.com billionaire. Based upon my experiences, I have learned that the same basic principles and lessons apply to a successful and healthy financial life, whether you’re starting out or cashing out. These guiding principles include simplicity, a long-term perspective, and above all, knowing that you have control of your financial destiny, and all the information you need is well within your reach.

To Own or Owe?

That Is the Question

You found the perfect house in your favorite neighborhood, worked with a great mortgage broker who came recommended by a friend, and just signed the mortgage documents. Congratulations! You have now entered into one of the biggest financial commitments of your life.

Mortgages certainly enable us to live the American dream, but they cost us dearly. Over 30 years, you will pay more than $400,000 in interest on a $250,000 mortgage at an 8% fixed interest rate. $400,000! You could reduce this eye-popping amount by prepaying your mortgage, but what is the value of prepaying? What would be the impact, for example, of paying an extra $200 each month from the beginning of the mortgage term? As shown in the following table, if you pay $2,000 rather than the required $1,800, then you shave 8 years off your time to home ownership. You also reduce your total interest cost significantly, to $275,000, or $125,000 less than without the extra payments!

On the surface, this strategy sounds like a no-brainer, but as with all matters financial, you should evaluate the trade-offs.

These trade-offs hinge around the opportunity cost of the extra $200 per month; that is, if you did not apply those monies to your mortgage, would you be able to earn a higher rate of return elsewhere (for instance, by investing in the stock market)? When you apply an extra $1 to your mortgage, you effectively guarantee yourself a rate of return on that $1 equal to your mortgage rate, with little or no risk. It is this rate of return that you should compare against other investment alternatives. (To make an apples-to-apples comparison, be sure to evaluate your alternatives on an after-tax basis.) To calculate the rate of return on your mortgage, adjust your mortgage rate–which is a pre-tax figure–to reflect the (federal) tax destructibility of mortgage interest:

Multiply your mortgage rate times 1 minus your marginal tax rate¹ to get your after-tax equivalent rate.²

(Note: this analysis does not reflect the impact of standard and itemized deductions; for information on your particular tax situation, consult your accountant.)

Now compare that rate with those on your investments. If your asset allocation is heavily weighted toward equities, for example, then paying off your mortgage might not be the better choice. If you have been achieving 20% rates of return, then your after-tax figure, assuming you hold stocks for more than one year, would be approximately 16%. So it seems as though you should invest additional funds, rather than prepay your mortgage. The problem is that you have ignored the volatility inherent in investing, and the volatility of equities in particular. Indeed, equity markets have posted healthy double-digit gains the past few years, but do not forget that the market–as measured by the performance of the Dow Jones Industrial Average–has earned an average of just over 10% per annum over the past 30 years and dropped 28% in 1974 alone. It is this market uncertainty that leads many financial advisors to recommend that you allocate at least a portion of any extra monies to paying down your mortgage.

The above methodology reflects conventional textbook wisdom. But what about the answer that reflects the emotional toll of debt? That, of course, is very personal. Some people view debt as a tool that they can use to achieve financial goals. Others view debt as an oppressive burden that keeps them awake at night. If paying off your mortgage would bring you peace of mind and happiness–and your lender does not impose prepayment penalties³–then by all means go ahead. Just don’t use tax-advantaged monies from a retirement account, such as an IRA or pension plan, to do so.

¹The amount of tax imposed on an additional dollar of income.
²In the above example, assume you fall into the 28% tax bracket. Multiply the 8% mortgage rate times 1 minus your marginal tax rate (1-.28 = .72) to find the after tax rate, in this case 8% x .72 = 5.8%.
³Some financial institutions charge borrowers a fee for prepaying certain loans. If a borrower prepays any of the principal on a loan, the bank does not generate the interest that it expected to receive on that amount.

This column is designed to provide accurate and authoritative information on the subject of personal finances. It is provided with the understanding that the Author is not engaged in rendering legal, accounting, or other professional services by publishing this column. As each individual situation is unique, questions relevant to personal finances and specific to the individual should be addressed to an appropriate professional to ensure that the situation has been evaluated carefully and appropriately. The Author specifically disclaims any liability, loss or risk which is incurred as a consequence, directly or indirectly, of the use and application of any of the contents of this work.