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
Without the interest payment, all the charity and other schedule deductions
OK - so do I pay it off and lose the other deductions,
and pay 15% more in taxes -
Which would you rather have: $5200 or $825. Your choice.
The other deductions aren't "lost." They simply are covered by the
Another way to look at it is that by itemizing, you are giving up the
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
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
-- Not being owned, via a mortgage, by these overwhelmingly crooked
banks should be incentive, AFAIC.
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
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
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
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
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
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.
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.
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
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.
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.
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.