Paying off a mortgage early is test of balance

Oakland Tribune, Dec 2, 2005 by Eve Mitchell, BUSINESS WRITER

SO YOU got the house, a big step in your life that took a lot of effort. Now it's time for another decision: Is it worth it to pay off your mortgage early?

Whether to prepay a mortgage depends on a variety of factors, experts say. Is there a financial penalty for paying off a mortgage early? Do you itemize mortgage interest on your taxes, and have kids to send to college? How close are you to retirement? Do you have retirement funds set up?

It all comes down to a balancing test. You have to figure out if you can get a better after-tax rate of return by using extra money to prepay the mortgage or to fund a tax-advantaged retirement account such as a 401(k), Roth or Traditional IRA or college savings plan.

Newark resident John Sorensen did the balancing test. He decided to prepay the $170,000 left on his mortgage. Each month, he pays from $90 to $140 extra toward his monthly mortgage payment of $960 on the house he bought 15 years ago. He wants to have his mortgage, which he refinanced a couple years ago, paid off before he retires in 20 or so years.

"That's the plan at this point," Sorensen said. The 45-year-old multimedia technician is married and the father of two young children. He already has invested in retirement and college funds.

"It's a balancing act. You cannot put it all in one place. I add money to the regular payment each month. It equals out to making 13 payments over 12 months," said Sorensen, who expects the extra payments will take about five years off his mortgage.

There are pros and cons to prepaying a mortgage.

Prepaying could be a good idea for someone who already has set up retirement funds, is nearing retirement and is no longer getting the financial benefit of mortgage interest deduction, said Greg McBride, senior financial analyst at Bankrate.com.

"You are looking for ways to trim your expenses once you retire," he said.

Prepaying also helps a homeowner build enough equity to eliminate private mortgage insurance or to refinance a jumbo loan at the lower conforming rate, he said.

On the other hand, a couple in their 30s with young children should consider putting extra money into a retirement or college savings plan, provided the after-tax rate of the return is expected to be higher than the after-tax cost of borrowing, McBride said.

Extra money also could be used to pay off higher debts, such as credit cards, he said.

Paying a mortgage off early while ignoring other investments can result in a less-diversified financial portfolio, McBride said.

"It leads to a concentration of wealth tied up in one asset -- the home," he said.

It's important to crunch the numbers.

"You can't make the decision emotionally or in a vacuum. You have to go through the exercise of what's the best use of this money," said Patricia Jennerjohn, an Oakland-based financial adviser.

Generally, itemizing mortgage interest on a tax return reduces the after-taxcost of borrowing money to buy a home from 25 to 40 percent, depending on the borrower's tax bracket, she said.

Say you're in the 25 percent tax bracket with a $500,000, 30- year fixed-rate mortgage with a 6 percent interest rate and $10,800 in closing costs. By taking the mortgage interest deduction, you would actually pay 4.218 percent in mortgage debt, according to a mortgage calculator at http://www.finance.cch.com/sohoApplets/ mortgagetaxes.asp.

To do better financially than prepaying the mortgage, you would have to find a long-term investment with an after-tax return higher than 4.218 percent.

Or, looked at another way, compare two homeowners with that same $500,000 mortgage: one invests an extra $200 a month and earns a 5 percent after-tax return; the other spends an extra $200 a month to prepay the mortgage.

Bankrate.com crunched the numbers and found that the first person came out ahead of the second by about $2,500 based on investment returns and additional mortgage interest tax deductions. But the second person still did well, paying off the mortgage in 251/2 years and saving $82,823.10 in interest.

"If you can do (better financially) on an after-tax basis on an investment than the after-tax cost of borrowing, you should make the investment instead," Jennerjohn said.

Keep in mind that you take on risk putting extra money into an investment, as opposed to the sure rate of return you get from prepaying a mortgage.

Many California homeowners itemize mortgage interest deductions on tax returns to help offset the high cost of housing here. In 2003, almost one-third of taxpayers filed for the deduction, according to IRS figures.

But as home loans get paid down, so too does the interest paid and therefore the size of the mortgage interest deduction.

"The quicker you prepay, the quicker you burn through the tax deduction," McBride said.

To benefit from the mortgage interest deduction instead of the standard deduction, a single borrower would have to pay at least $5,000 in mortgage interest while a married couple filing jointly would have to pay at least $10,000 in mortgage interest for tax year 2005.