# mortgage - payoff vs deductions

I've been re-reading the subject of paying off our mortage
vs the deduction that it generates.
SO.... here are the real 2008 numbers,
but I can't determine how to view the choice/results.
last couple of years itemized deductions = \$16,000
Interest 1098 form = \$5,232
With itemized deductions of \$16k, tax owed was \$5,260.
With std deductions of \$11k, tax owed would be \$6,085.
The difference would be \$825
Therefore, paying \$5,232 in interest generated a tax saving return of \$825,
probably due to the fact that all our other deductions were now over the std
deduction.
Without the interest payment, all the charity and other schedule deductions
are eliminated.
OK - so do I pay it off and lose the other deductions,
and pay 15% more in taxes -
or ??
Which would you rather have: \$5200 or \$825. Your choice.
The other deductions aren't "lost." They simply are covered by the standard deduction.
Another way to look at it is that by itemizing, you are giving up the standard deduction.
Dave
What interest are you getting with the money that would be used to pay off the mortgage? Is that interest tax free?
-- Ron
Dont forget the strategy of "bunching". That is making two years worth of dedcutions in one year and none in the next year. For example you'd makeas many 2010 deductable payments in late December 2009 or early January 2011. Things like property taxes, states taxes, charity, etc.
In the doubled-up years you'd itemize. In the other year you take standard deduction.
Another wrinkle: in 2008 and 2009, non-itemizers are able to deduct up to \$1000 in property tax (married, filing jointly, with tax at least that amount). So that one isn't lost if you use the standard deduction. If that's not renewed for 2010 and beyond it could skew your future comparisons a little.
A way to view your decision, if the \$825 figure is correct (if you used TurboTax or similar it should have included the property tax), is that you effectively paid \$4407 in interest on some amount of debt. Let's say it was \$100,000 in debt...that would be 4.407% interest. Financially speaking you can call that your "cost of funds."
The \$100,000 you have sitting somewhere would need to earn 4.407%, after tax, to break even. If it earns more, you're getting slightly ahead, and if it earns less, the mortgage is costing you real money.
That's just looking at the "horse race" comparison, of \$100k invested vs. \$100k borrowed. Another factor is the advantages of having \$100k liquid - sitting somewhere, easily accessible. Once you pay off the mortgage in full you might decide you wanted the money to spend on something (eg car), and now you'll just have to borrow it back out again.
I concur with all responses to date. What also came to my mind was:
-- I doubt CDs under five years are going to pay over 4% anytime soon. The Fed will keep interest rates yada low for at least another year or so, I imagine, to keep giving people some incentive to stay invested in stocks. Bankrate.com says 5-year CDs are paying around 3% on average right now. Paying down the mortgage, and so saving all the expense of mortgage interest, seems sufficiently justified.
-- Do you have an emergency funding plan, anticipating, say, a new roof or a car purchase or an appendectomy with complications or loss of a job for a while? If so, this further justifies paying off the mortgage.
-- Not being owned, via a mortgage, by these overwhelmingly crooked banks should be incentive, AFAIC.
thanks for all the replies... yeah, just looking at the horse race.. Funding is not an issue, as there is plenty of cash laying around.
First, you have to bump your standard deduction a bit - for 2009 & 2010 nonitemizers can ADD up to \$1,000 in real estate taxes to their standard deduction. It doesn't look like you figured that in to your equation. Since you ignored it, so will I.
Second, you have to consider that you PAID \$5232 in interest to get the government to give you BACK \$825. Most people would rather PAY the government the \$825 and KEEP the \$4407 (\$5232 - \$825).
Third, you have to consider what you're earning on the cash you have stashed that you'd use to pay off the mortgage and how much money we're talking about.
If you JUST got a 30-year loan at 3.875% for \$140K then you have about \$140K in cash that you've invested elsewhere. On the other hand if you're in year 29 of a 30 year note for \$400K at 9.0% then you only have about \$40K available AND you're going to be paying off this note in the next year anyway.
Giving up \$140K in liquid cash that you might need for something else that isn't due for 29 more years is considerably different than having to give up \$40K just 12 months early - remember if you're in the last year of a high interest loan you're going to paying it off soon anyway.
Next you have to consider what earnings you'd be giving up if you use the cash to pay off the mortgage. If you're earning just 4% on a \$140K when your mortgage rate is 3.875% you're just a little ahead by keeping the mortgage. On the other hand if you're earning 8% when your mortgage is 9% and it is going to be paid off in 12 months anyway . . . well, you do the math.
AND after you work through all the numbers you have to factor in the qualitative, nonmonetary things like -
A - will you or your wife sleep better at night knowing your home is paid for? B - will you or your wife sleep better at night knowing you have \$140K available in case something happens?
Hope this helps, Gene E. Utterback, EA, RFC, ABA
Can you please quantify the difference?
TIA
Since the mortgage is the thing "on the margin" (the thing you are thinking about changing), then you should consider that last. It didn't put the other deductions over the std deduction, rather the other deductions put it over the std.
But you get the std deduction instead. So they are not eliminated, they are magically elevated up to the std. Since 16k-11k is about equal to 5232, it doesn't make all that much difference anyway. But to the extent it does, it is in the other direction. Your interest payment drops by 5232, but your deduction drops only by 5000, because the std stops it from dropping further.
Is your primary goal to increase your money, or to deprive the government of money? paying \$825 less in taxes but costing yourself \$5232 in interest to do so is a peculiar form of economizing. Of course, the other variable is what you would do with the cash if you didn't use to pay off the mortgage.
Xho
Another way to look at this kind of choice is in terms of risk. If you pay off the mortgage, you have a sure thing; that is, you have gained the 4.4% no matter what happens in the future. If you leave the mortgage alone and invest the money elsewhere, you would have to gain more than the 4.4 figure to come out ahead. That may or may not happen. At present, it is far from a sure thing. The real comparison should be between 4.4% on the one hand and the average expected gain or loss from other investments you may decide to make, on the other hand.
In other words, don't compare a sure thing of 4.4% in mortgage payoff with a possible but questionable 5.4% in stocks.
Of course, this comparison ignores tax considerations. Personally, another big consideration would be simply the psychological boost of getting rid of the mortgage and not owing money to the bank.
Of course, under scenario A, you could get a home equity loan for at least part of the \$140K in case of an emergency. You could sleep well and still have something of a nestegg.
Don writes:
Do NOT NOT NOT count on a home equity line as an emergency fund. It is not the same. In many cases, the emergency which necessitates the funds also causes the HEL to get frozen and/or closed. (ie. the recent recession and all the job losses).
That is good to know. Someone once told me that when you lose a job, you should immediately go to the bank and get a personal loan before telling anybody about your misfortune. If a home equity loan is not an option, my plan B would be keep about \$20,000 in savings for emergencies and use the remaining \$120,000 to pay off the mortgage or most of it.
This does NOT work for mortgage interest and its use is limited for other deductions. But in general it works like this -
The standard deduction for a married couple is \$10,900 and we can now tack on up to \$1,000 for real estate taxes so it becomes \$11,900. Let's say that all of your itemized deductions, including \$5,000 in charitable contributions, totals \$\$12,000. You get to itemize but the only benefit you get from a \$5K charitable deduction is \$100. If you're in the 25% tax bracket you save a whole \$25 in tax.
So here's what you do -
In 2009 you do NOT make any charitable contributions AT ALL and you use the standard deduction. This costs you \$25.
In 2010 you make DOUBLE the charitable contributions. NOW your itemized deductions are \$17,000 and the charitable portion saves you \$1,275 (total itemized of \$17,000 less standard deduction of \$11,900 equals excess itemized of \$5,100 times 25%).
In 2011 you make NO charitable deductions. In 2012 you double up again. Lather, Rinse, Repeat
The reason it doesn't work for mortgage interest is that you cannot normally prepay interest with your regular payment. Any extra you send in gets posted against principal, your note payment amount stays the same but you wind up making fewer payments - it comes off the back end.
The reason it doesn't work for most other deductions is that there are limitations on how far in advance you can pay for things. The tax assessor isn't usually able to keep your money if you prepay your taxes in advance - most jurisdictions now actually collect real estate taxes twice a year instead of just once. And there are similar prepay limits on business expenses.
It will sometime work for medical expenses, especially if you're filing a joint return and there is a big disparity between spousal incomes. For example, if you make \$150K a year and your wife makes \$50K a year - you live off your money and your wife pays for all the medical bills out of her money, but she pays them every other year AND you file separate returns.
This is tax planning that is beyond many taxpayers but it is the kind of thing tax professionals used to do all the time. I say used to do because, sadly, most of the other tax pros I know shy away from tax planning. IMNHO this is due to two big reasons -
First - we charge for this work and taxpayers who've paid for these services but then don't follow the plan wind up not getting the tax benefit they anticipated. Not our fault, but an unhappy client is not a loyal client.
Second - we charge for this work and most people don't want to pay for it; it can also be cost inefficient. The calculations necessary to identify and locate the areas where this will work will take between 2 and 5 hours, on average. Our rate for tax planning is \$200 an hour, so our fee could be \$400 to \$1,000. In the example above, if our fee was \$1,000 and it saved you \$1,250 you'd be \$250 ahead BUT ONLY if you followed the plan.
And the two biggest reason these plans don't get followed are -
One - for business expenses most of your vendors don't want to get paid only every other year.
Two - if you're making charitable contributions sufficient to make this work for you, expect some pressure from your friends and the church for not making regular even contributions so the church will have a steady cash flow for operations. Now some will say the way around this is to work with a close friend from the church so that you alternate years - you paying double in year 1 and nothing in year 2 and your friend paying double in year 2 and nothing in year 3, and so on and so on. The problem is escalates when one of you gets used to NOT making regular contributions and when your turn comes you don't have the necessary amount available - remember, the nice thing about budgeting is converting large payments into smaller, easy to handle payments (think withholding tax - how many of us would actually save up all year and be able to write a big check to the IRS on 04/15 consistently, year after year?).
Hope this helps, Gene E. Utterback, EA, RFC, ABA
While this has been a readily accepted and widely used option in the past DO NOT count on this in this economy. I cannot tell you how many of my clients have written checks against their HELOCs only to have them bounce because the line was either reduced or closed and they didn't catch the notice. I even had one client write a check for a new truck on a Saturday at a dealership his family has been using for decades only to have the check bounce - AND the dealer could not (or would not) take the truck back. This forced them into dealer financing at a rate that they would NEVER have agreed to otherwise.
Illegitimi non carborundum (don't let the bastards wear you down!) Gene E. Utterback, EA, RFC, ABA
I guess that possibility is another "emergency" for which there should be some kind of protection. One thing that should be borne in mind is that a homeowner with no mortgage is in a relatively favorable position in case of loss of a job or similar misfortune, because there is neither rent nor mortgage payment due each month. Paying off the mortgage would still be at the top of my list for what to do with new money, with some emergency fund held back, of course, for those awful things that might happen.
Don writes:
Note that that's a *fully* paid off mortgage.
If you can only pay down half your mortgage, your monthly payments are unaffected. You just have less cash on hand. This is an argument for saving *outside* the mortgage until one has an emergency fund - and only *then* prepaying the mortgage (either fully or partially). If one has enough cash to pay off the mortgage entirely - and still have enough left over for the (now not necessarily as large) emergency fund, then paying if off completely may make sense.
But make no mistake - a paid-off house is NOT a substitute for the liquidity of an adequate emergency fund or for meeting other ongoing cash payment needs.
(btw, I highly recommend googling or "home equity frozen" to see some of the horror stories associated with these issues)
One more wrench to throw into this is that the freezing of the HELOC often takes the form of them lowering your credit limit down to your outstanding balance. Not only does that cut off a source of liquidity for you, but it can also immediately whack your credit rating as your ratio of credit used vs. credit available suddently jumps -- thus making a frozen HELOC not only potentially painful in itself but it can also impact your ability to get any other new credit at that same unfortunate time.
Would not a paid-off house be a big plus in getting a new loan from some other source in case a HELOC from the bank is no longer an option? Granted, the interest rate could be much higher and painful, but we are looking at rather extreme circumstances where a lot of things go wrong. Even a large emergency fund will eventually be gone if you have to continue making monthly mortgage payments.
Don writes:
Sure. But if the reason you need the loan is because your cashflow has gone to nil (ie. because you've lost your job), the lender is just as interested in that.
Lenders don't want to lend you money on your house if they think you're going to be unable to pay it back and have to resort to selling the house or handing the house over to the lender. They want to lend you money that you can pay back out of income. Foreclosures stink for the banks, too.
The main exception is reverse mortgages and they make up for much of the hassles associated with waiting for sell-off for payback by having huge fees and lots of restrictions and high rates.
It should be large enough to cover your expenses while you either find a new source of income - preferable - or to cover your expenses while you work to reduce those expenses in an orderly fashion (ie. selling off the house you can't really afford and moving someplace you can - the extreme scenario).
Either way, an adequate emergency fund allows you to actually make those mortgage payments - and pay your taxes and buy your food and pay for your insurance and all the other essentials. It's awfully difficult to pay for food and insurance out of an illiquid asset like a paid-off house -- unless you sell the house or borrow against it. And the inability to borrow against it is *exactly* the sort of emergency for which one needs cash on hand. The whole point is - don't overestimate your ability to borrow against your house when that emergency arises.
Even with a paid-off house, you still need an emergency fund, though perhaps a smaller one. If your house is only *partially* paid off, your emergency fund needs to be full-size - a partially paid off mortgage (ie. because you've been paying extra principal each month) has monthly payments exactly the same size as had you not partially prepaid.
The question of "pay down my mortgage vs. invest/save" rarely is "pay off the mortgage completely vs. invest/save". In those rare cases where it is the latter, that's great. But if someone starts using their emergency fund to partially prepay, he is potentially taking a huge liquidity risk.

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