Thinking of Paying Off Your Mortgage?

[Originally posted December 2016]

So you’ve been living in your home for a few years now and you’ve noticed that your mortgage balance is getting to an amount that you could possible pay off – you’d be able to live mortgage free. While there’s a certain amount of peace of mind in not having a mortgage payment due each month, is paying off your mortgage a good idea?

As with a lot of tax planning questions, the answer is, “It depends…”

  1. First off, mortgage interest is only tax deductible mortgage interest if the mortgage meets two tests: it has to have been used to purchase the house and it has to be secured by the house. So, if you paid off the mortgage and in a couple of years decided you needed to borrow against the house to do something else (finance college for kids or grandkids, purchase an investment property, etc), the interest on a new mortgage to generate the cash to do that won’t qualify as home mortgage interest. While it’s true that such mortgage debt will currently qualify as deductible under the home equity indebtedness rules, the amount is limited to the interest on $100,000 of debt. Additionally, as we discussed in an earlier blog post, there are no assurances that the mortgage debt rules as to deductibility will remain the same as the current uncertainty as to the tax rules plays out over the next year or 18 months. It’s probably safe to say though that home mortgage interest for purchasing a home (compared to home equity indebtedness) is less likely to be limited that other types of debt.
  2. If you’ve been the beneficiary of some of the very low mortgage rates offered in the last few years, you may want to hold off on paying down your mortgage. Interest rates are expected to rise, which often means that investment yields in general may rise as well. Keeping that low interest rate mortgage debt alive while investing the money you would have used to pay it off in something at a higher rate makes a lot of investment sense.
  3. If you pay off your mortgage, you’re giving up money for a rainy day fund for yourself – you may want to use those funds later on for things ranging from unexpected medical expenses to an elderly parent’s long-term care costs to home repair expenses, etc. Depleting your cash to pay down your mortgage may reduce your financial options in the future should unexpected life events occur where you needed the money.
  4. If paying off your mortgage would involve taking money out of your qualified retirement plan like an IRA or a 401(k), STOP! If you’re under 59 ½ years old, taking the withdrawal will mean paying an IRS penalty on the withdrawal. Additionally, unless you’d be taking the money from a Roth IRA, the withdrawal will be subject to tax on the lump sum withdrawn as ordinary income.  Plus, withdrawing the funds could end up nudging you into a higher marginal tax rate overall.
  5. If you haven’t maxed out on the contributions you can make to a qualified retirement plan, consider making those contributions rather than paying down your mortgage. If the contributions are to a plan other than a Roth IRA, the contribution is tax deductible, so you’ll save on current taxes by making the contribution, something you won’t do if you pay down your mortgage.

All of that said, a lot of the time clients want to pay off their mortgage has less to do with making tax or financial sense than buying personal peace of mind – however, make that decision being fully aware of the ramifications.