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The Pros and Cons of Paying off Your Mortgage
With all the recent focus on lending practices, foreclosures and economic pressures in general, I've been getting a lot of questions from readers concerning the pros and cons of paying down a mortgage. Understandably, many people are concerned that carrying a mortgage might be a detriment to their financial future. And those struggling to meet their monthly mortgage payments are wondering if there's any light at the end of the tunnel.
First of all, I want to stress that having a mortgage isn't necessarily a bad thing. In fact, because of tax deductibility and relatively low interest rates, a mortgage can be a valuable part of your financial plan. If you have a fixed-rate, affordable mortgage, you may be just fine sticking with your current payment schedule.
But there are ways to look at your mortgage and handle your payments that can help you feel in greater control as well as decrease your debt burden overtime. For those folks close to retirement, this might be especially interesting, since lessening debt in this phase of life can be both economically and psychologically freeing.
So back to the question: Should you try to pay down a mortgage early? Seems simple enough, but the answer is a bit more complicated. It depends a lot on your personal situation, including tax issues, how you feel about risk, your current portfolio and what else you might do with the money. However, when you look at your mortgage in the broader context of your overall financial health, there are some general considerations that can help you decide if and when to make paying off your mortgage a priority.
WHAT TO DO BEFORE PAYING DOWN A MORTGAGE
As I said before, carrying a mortgage can be a positive part of your financial picture. And the extra dollars you put toward decreasing your mortgage may actually be better spent elsewhere. Before focusing on your mortgage, make sure you've first covered the following bases:
— Have you saved enough for retirement and taken advantage of any available employer match within your company retirement plan? To me, this should be number one on your list. At the very least, contribute enough to take advantage of any available employer matching contribution. Failing to do so is similar to leaving free money on the table.
— Have you paid off your "expensive" debt? High-interest, non-deductible debt (the opposite of a mortgage) is the type of debt to get rid of first. For most people, that means credit card debt and possibly an auto loan. If you have multiple credit cards, start by eliminating the amount on the card with the highest rate. Not paying that extra 13 percent to 18 percent a year could ultimately give you more cash to put toward your mortgage.
— Do you have an adequate emergency fund? Everyone should have at least three months of non-discretionary living expenses stashed in a safe, liquid investment vehicle for that proverbial rainy day. If something happens — an unexpected illness or unemployment — your emergency fund can help you avoid more debt. And the fund might keep you out of foreclosure.
— Have you maxed out your retirement savings contribution? Assuming you've already taken advantage of any available employer match and have an adequate emergency fund, your next step should be to fund your retirement accounts to the maximum the law allows, if possible. If you're over 50, take advantage of the "catch-up provision" and add extra money to your 401(k) or IRA — up to $5,000 per year for 401(k) plans, and up to $1,000 for IRAs and Roth IRAs.
— Have you saved for your child's education? This may not apply if you're nearing retirement, but setting aside money for a child's education — through tax-advantaged vehicles like 529 plans — could be higher on the priority list than decreasing your mortgage amount.
— Do you have a home equity line? If you do, it's probably at a higher rate than your underlying mortgage; it only makes sense to pay down your equity line first.
WEIGHING THE TAX BREAKS
Tax-deductible interest is often cited as one of the biggest pluses for carrying a mortgage.
Currently you can deduct the interest expense on up to $1 million of home-secured debt — used to purchase or make capital improvements on your qualified principal and/or second residence. You may also subtract the interest expense on up to $100,000 of home equity debt secured by your home, whether in the form of a regular loan or revolving line of credit. But once you've paid off the original mortgage, you'll be limited to the $100,000 home equity debt ceiling, unless you make capital improvements or buy another home.
You need to carefully consider how your mortgage interest deduction impacts your overall tax situation. Consult your tax adviser if you have questions.
TWO MORE IMPORTANT FINANCIAL CONSIDERATIONS
If you have all your other financial ducks in a row and you've decided that the tax advantage doesn't warrant carrying the mortgage debt, there are two more financial questions to answer before you start making extra payments:
— What's your "after-tax opportunity cost?" Figure out what your mortgage loan "really" costs once you've factored in the tax deduction. Compare that with your potential investment return. For example, if you're in a 40 percent (combined federal and state) tax bracket, your 6 percent mortgage loan effectively costs you 3.6 percent.
Could you make better than a 3.6 percent after-tax return by investing in the financial markets rather than paying down your mortgage? The answer is probably "yes." But the flip side of that involves investment risk; the return is not guaranteed. Paying off your mortgage is a risk-free proposition that nets you 3.6 percent. In the end, your decision is a balance of risk and reward that depends on your own level of comfort with that risk.
— Does your mortgage have a prepayment penalty? Typically, traditional mortgages don't contain prepayment penalties, but you should certainly confirm that before you move ahead.
AND THEN THERE'S QUALITY OF LIFE
For many people, particularly those nearing or in retirement, the comfort derived from being debt-free outweighs all other considerations. And no one can argue with that. If paying off your mortgage is one of your goals, you can do it in small increments (even one extra payment a year can take years off your mortgage). Or you may pay a lump sum at some point prior to your final due date.
Whatever your decision — you might want to talk through your options with a financial planner — make sure the terms of your current mortgage are the best you can receive. Having the right mortgage at the right time can be the ultimate answer. After all, a mortgage often represents more than a financial investment; it represents home, family and hopes for the future.
Paying too much for your mortgage can get in the way of your other goals and dreams; therefore, decreasing the amount steadily may be the best way to meet your current goals. And for a lucky few, paying it off completely can be a dream come true.
Carrie Schwab Pomerantz is Chief Strategist, Consumer Education, Charles Schwab & Co., Inc., Member SIPC. You can email Carrie at email@example.com. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.
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