Does it pay to pay down the mortgage?
Original post:
> To compare the advantages of paying down your mortgage,
>you need to reduce the interest rate of the mortgage by
>your marginal tax bracket to get the after-tax rate of
>return. If you've an 8% mortgage and are in a 31% +
>6% (state) bracket, then your rate of return for paying
>down the mortgage is a net 5%. That's not a difficult
>number to beat even with a taxable investment, but you
>should consider the relative risk as well.
Micheal's reply:
Actually -- that's not quite right. Paying down a mortgage is equivalent
to earning the mortgage rate in a taxable investment. Paying down
non-deductible debt is equivalent to earning the interest rate on the debt
tax-free.
Your earnings from paying down the debt come in the form of money that
don't have to pay in interest, so it's not taxed the way realized cap
gains or dividends are taxed -- it's tax free.
Now, mortgage interest is paid with before tax dollars, so the tax free
nature of the earnings involved in paying down debt gives no advantage
(there was no tax on that money), but it's still very much 8% -- you don't
have to reduce the 8% by your marginal tax rate -- because there isn't a
tax on interest saved.
So, when paying down debt, you make the tax adjustment on *non-deductible
debt* making it more valuable to pay off than the nominal interest rate
would indicate. That's the reason paying down debt is often a no brainer,
the earnings it produces aren't taxable. If the debt is non-d, it's a tax
free investment.
> One unusual factor in your particular situation is
>your short time horizon -- only two years left on the
>mortgage. It's not the usual situation of investing
>for 25 more years versus paying down the mortgage.
>With such a short time span, low-risk alternatives
>will have a much harder time beating that 5%
>number.
And a *really* hard time beating the 8% number, that he's really aiming
for. Trying to beat that 8% is only realistic if you can invest primarily
in stocks for 10+ years -- even then, I'd be iffy about it.
> Buying a bigger house just to get a tax deduction does
>not save you money. It costs you more money. It just
>doesn't cost quite as much as it would were the mortgage
>not deductible.
I wish more people understood this. I can't recount how many people were
advising me to get as big a house as I could possibly afford, and really
didn't understand when I said "That only makes sense if it's a *perfect*
house."
Got lucky and found one anyway...
Michael
(
geocities.com/vyque)