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Pre-paying a mortgage?

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This entry was posted on 6/9/2007 9:39 PM and is filed under uncategorized.

I've been asked if it makes sense to make pre-payments on a mortgage? Disregarding income taxes for the moment, it usually does. If you have $10,000 earning interest of say 3 percent, and your mortgage has a rate of 6.5%, you "earn" an additional 3.5% by investing the $10,000 into your mortgage. The money you will save over the life of the mortgage, will give you a return of 6.5% on your $10,000. Not having to pay interest of 6.5% is the same as earning it. One problem with doing this is you can't easily get your $10,000 back out of your mortgage if you decide you need it.

Taking income taxes into account complicates the situation. Not having to pay taxes on the 3% earnings of the $10,000 lowers your taxes by let's say $45/year. Not being able to deduct the interest on $10,000 of mortgage, raises your taxes by about $95/year, so you lose $50/year here, but that is offset by you earning an additional $350/year. I assumed a 15% tax bracket here, so I think we can say, income taxes reduce the benefits I wrote about in the first paragraph, but only by 15%. So in this case, you only got 85% (1.00 - .15) of the benefit. If your tax bracket is higher and/or you pay state income taxes, your benefit will be reduced more. Also, a lot of people don't itemize, so a lost mortgage deduction, is irrelevant, which would mean, pre-paying your mortgage lowers your income taxes since your interest income is less.

Debt isn't everything some people claim it is. The value of its write-off is in many cases, overstated.

 

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    • 8/20/2007 1:03 PM Aury wrote:
      Hi, I like the way you think! I would appreciate your opinion on my situation and questions.
      We are married, filling jointly, aged mid 30's Gross income will be $23000, federal taxes paid about $1300. We have one 3 year old child.
      We want to cash in our 401k, IRA and roll over IRAs. They total only $18000. Withholdings will be $1800.
      We want to put this amount on our mortgage and save $14500 in interests. This will allow us to pay off our mortgage by 2010 and buy a second home (for retirement rental income).
      My questions are:
      Does this make financial sense to you?
      I estimate that we should still get $1800 back when we file our tax return, am I right?
      Reply to this
      1. 8/20/2007 2:25 PM David Greenslit CPA wrote:
        With Gross Income of $23000 (all of it earned income), MFJ and one child, your taxes would be about $280 which is offset by the Child Tax Credit and the Earned Income Credit which would give you a Federal refund of about $3800 (assuming $1300 in withholding). These numbers are projected, using my 2006 Income Tax software. If you take the distributions, you new numbers would be: an income tax of $2369 offset by the Child Credit of $1000. You loss the Earned Income Tax Credit because of a too high income. There is a 10% penalty tax on the distributions, unless you can find an exception. You do get credit for the $1800 in withholding. The net of all this is that you about break even if you take all of the distributions. So you net tax increase for taking the distributions is the $1800 you they take plus the change in your refund. That comes to $5600 while ignoring any state income taxes. That is too high a cost to pay to liberate these funds. To see more precisely how this effects you, run two tax returns. One with no change and one with the distributions. You don't need tax software to do this, it just is easier to do. 

        To trade retirement plans for not having a mortgage is not something that is typical of what I see. There is a better argument for getting rid of taxable investment accounts to pay off a mortgage that may give you limited tax savings.

        I do know that rental properties are often risky with their best attribute being their probable appreciation. Breaking even on them from year to year is about average.

        Because of the high tax effect, I can't recommend you do this, but further analysis is needed. One option is to take small annual distributions from your deferred accounts. I'm not saying small distributions can be found to make sense, only that the negatives may be smaller or deferred. And of course, the other option is to do nothing and see if your situation changes? 
        Reply to this
    • 8/21/2007 8:15 AM Aury wrote:
      Thanks for the quick reply.
      The balance on our mortgage is $29,400. The property is single family, built in 2006, good school district, etc..bought for $200,000. We got the mortgage in April 2006 and we want to pre-pay because it's early in the loan. We have zero other debts.
      Because our income is so low we can't afford child care and so I won't work full time until 2009 and by then extra payments on principal won't be as beneficial..
      The almost $2,000 in interest that we pay a year represent almost 9% of our income!
      the money in IRA, 401K, Roth IRA has been there over 10 years and it was worth more then..What if we cashed out a little less, would we still qualify for the Earned Income Credit?
      We understand that rental properties don't increase much in value, but they pay for themselves if we get the right one.
      We just don't want to owe anything to anyone..
      Reply to this
      1. 8/22/2007 12:45 AM David Greenslit CPA wrote:
        The almost $2000 in interest you are paying is most likely not doing you any good because you probably take the standard deduction. You are correct that pre-payments are most effective when made early in the life of the loan.  Your preferred source from your retirement accounts is your Roth IRA. Roth distributions are generally tax free, but there are exceptions. See Investopedia. It's my opinion that they do not effect your earned income credit. So beyond distributing the Roth, I think the tax costs are too high.
        Reply to this
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