A reader e-mailed me this week to ask if they should pay off their mortgage or invest in their 401(k) for retirement. There are a lot of things to consider when making this decision, so there is not a single right answer for everyone. Here are a couple of questions I would recommend asking yourself when deciding between debt pay off and saving for the future.
If the answer is “Yes” then move to the next point. If the answer is “No” then I would strongly advise putting any extra money that you can towards building an emergency fund with 3-6 months of living expenses.
“What is my mortgage interest rate?”
If your mortgage rate is at 6% and you pay it off, you have gotten a guaranteed rate of return of 6%. This means you would need to get at least 6% in the market in order for investing to make sense, and really it needs to be a lot more to make up for the risk of the market versus the guarantee of paying down debt. If your mortgage is at 2.75%, it may not be quite as clear cut of a decision as if you are at 6%.
“What is my tax rate?”
Since mortgage interest is tax deductible, a 6% mortgage isn’t actually 6%. If you are in the 35% tax bracket, then a 6% mortgage actually costs you about 3.9%. To get your actual mortgage interest rate, use the following calculation: Interest Rate * (1 – tax rate). For instance, the above example would be: .06*(1-.35) = .039 or 3.9%
“Do I itemize my deductions?”
According to a 2005 study, only 54% of Americans paying mortgage interest actually get a tax benefit. This is because you can only deduct your mortgage interest if you are itemizing your deductions. Take a look at last year’s tax return to see if you even itemized. If you did, how much more were your itemized deductions than the standard deduction? If this isn’t a large number, then the above question of “What is my tax rate?” will be irrelevant.
When I ask clients this question, they always respond with NO! What if the interest rate to take out the loan was 5%? How about 3%? I can never get one to take me up on it. This is actually no different than choosing to save instead of paying down the mortgage! If you have $100 and decide to invest instead of paying down your mortgage, you are especially borrowing money to invest in the market. If you wouldn’t do this directly, why would you do this indirectly?
So what is the answer? As always, the answer is IT DEPENDS! Beyond the numbers, there is a huge psychological benefit to being debt free. I have never had a client pay off their mortgage and later regret it. I do believe though that you have to find a balance between paying down debt and saving for the future. If you have an emergency fund, I usually recommend at least fully utilizing your employer match on your 401(k), and then pay down debt as much as possible. Most clients chose a combination of debt payoff and savings, which is typically a good path to take.
So what do you think? Are you trying to decide between debt pay off and savings? Have you paid off your mortgage and have advice for other readers? Feel free to share!