With interest rates near their all time lows, I want to write a few blogs about mortgage debt. It’s a question we get asked all the time: “Should I pay off my mortgage quicker than scheduled?” Before we answer that question, I want to explore the true cost of carrying mortgage debt. The factors that influence the true cost of your mortgage debt are:
1. APR (ie interest rate). For this example, let’s assume you get a 3% 30 year mortgage in the current market.
2. Tax rate. For taxpayers that itemize their deductions, mortgage interest is deductible. So, let’s assume you are in the 24% federal marginal bracket and you pay 6% in state tax (in GA) for a combined 30% marginal rate. Therefore, your after tax cost of the mortgage is :
Interest rate x (1 – tax rate) = After Tax Interest Rate
In our example, your after tax interest rate would be 3% x (1-.30) = 2.1%
Note: If you don’t itemize your deductions, then you do not benefit from the “after tax” calculation/adjustment
With these two points in mind, how should you think about mortgage debt? If you own your house for 10 or even 20 years, then you still realize the appreciation of the house regardless of if you payoff the mortgage quicker than scheduled. So, by paying off the mortgage quicker, you’re only saving the after-tax interest (in our example, 2.1%). If you choose not to pay off the mortgage, you’ll pay the 2.1% to carry the debt, but you may have other investment opportunities with an expected return that is higher than 2.1%.
The wealth maximizing decision would be to carry the debt (ie NOT pay off the mortgage sooner than scheduled) and invest in an asset with an expected return higher than 2.1%. If your bet pays off, you’ll earn the spread and increase your net worth by the difference compounded over time.