May 11, 2009

Does the mortgage interest deduction make carrying a mortgage worthwhile?

Since announcing our intention to pay off our mortgage in six years, I've been asked if that's wise, given that the interest on a mortgage is tax deductible. The short answer is, it doesn't really matter to me. Paying off the mortgage will free up a lot of cash flow, which in turn will open up lots of options for us - options that I most definitely want to have in six years, because they may include things like the very expensive private school that we can't afford right now.

The long answer is - no surprise here - it depends - on whether you can earn more money with the extra principal payment than you would save by paying off that amount of principal. The math gets kind of complicated (at least for me), and I'm not a CPA or tax lawyer, so let me know if I haven't got this right.

Let's say that you'll pay $10,000 in mortgage interest this year and are in the 25% tax bracket, meaning that you'll pay $2500 less in taxes thanks to your mortgage. Let's also assume that if you pay an extra $250 per month in principal, you'll reduce your mortgage interest to $9,000, and therefore reduce your tax deduction to $2250. In other words, you'll end up paying $250 more in taxes this year because you paid off $3000 extra in principal ($250 x 12) . But you also paid $1,000 less in mortgage interest, for a net gain of $750.

Now, suppose you could take that $250 per month and invest it somewhere and earn more than $750 over the course of the year (plus more, to cover the taxes you'll owe on the extra income). Then theoretically, you're better off not paying extra on the mortgage but going with the investment instead. However, it also occurs to me that the math ought to be even more complicated because the mortgage interest savings are probably compounded over the life of the loan - that sort of calculation is way beyond my abilities, so I'm not even going to attempt to go there.

In my case, I haven't run the actual numbers to see if we could earn more via investment than we'll save by paying off the mortgage early. I don't even want to attempt those calculations, and in any event, it doesn't matter because I would predict the gain wouldn't outweigh the options that I'm looking forward to having in six years. And for us, that's what really matters.


Michael Harr @ Wealth...Uncomplicated said...

CFO - you are 100% right to payoff your mortgage early. While the math nerds out there will attempt to dispute this strategy, when properly done, even the math analysis says it's a good idea to payoff the mortgage. I wrote an extensive piece on this using the same tools as a professional advisor (monte carlo analysis) that you can view at

Trust me, you're doing the right thing...and your point about freeing up cash flow for other endeavors...that's priceless anyway.

lbellomy said...

I agree that paying off the mortgage is rarely ever the "wrong" choice. Dave Ramsey would say that if you want to pay $1000 to save $250 in taxes, you can always make a charitable contribution.

PK said...

Lastly, don't forget that behavior has a lot to do with this. Assume first for a second that someone really could be better off keeping the mortgage. Now, is that person really going to take the tax savings and invest them? Especially consider that this person HAS crunched the numbers to determine it, so they'll be getting the tax savings spread out over a year's worth of paychecks. So the outlined situation gets $10 extra if paid biweekly? You think that will be moved over to pad the investment account that is already on autodraft? I think not!

Kacie said...

Best wishes with paying off your house so fast! It's definitely a good move.

People like to make the argument that you can do better by taking the tax benefits and investing the difference. Heh. Have they seen the stock market lately?

Paying off your house is a GUARANTEED return on your investment. And, as you've said, you'll be freeing up a ton of your monthly income once the house is paid off.

Anonymous said...

In my experience, tax deductions are never comparable to actual income. Even if you end up owing zero tax for the year because of deductions like mortgage loan interest, you only get back money you've already paid, which has been sitting, earning no percentage. That money is much better used when earned.

Small Steps to Health said...

My husband and I brought our first home a few months ago. We are also planning to pay off our mortgage sooner 30 years. Our reasoning is like yours - we want more flexibility. As for tax savings, well, I can just contribute more money to my 401k.

I think it is problem for people who will end up blowing the mortgage payments on consumer products if they have no mortgage. My husband and I just want more free time (without a mortgage payment) we can survive on one income or both of us working part time.