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When Does Paying Off Your Mortgage Ahead of Time Make Sense?

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Many years ago, my wife and I hosted a neighborhood get together at our house.

It was our first home, on which we closed at a time of great financial instability. The prime lending rate had climbed to an unprecedented 21.5% in December 1980. And, although the rate that we ended up paying for our mortgage — 15.375% — is inconceivable by today’s standard, we were nevertheless pleased to secure what was, at that time, considered a cut-rate deal.

As you might expect, we actively monitored the money markets from that point on, with the intention of refinancing our mortgage when rates declined enough to justify doing so.

Unfortunately, double-digit interest persisted for several more years, and we ended up moving at about the time refinancing would have made sense.

Back to the party.

Because our street was a relatively new one, most of our neighbors were in the same boat as my wife and I were with regard to the high interest rates that we were all paying on our mortgages. So it should come as no surprise that we spent a lot of time commiserating about that.

As a finance guy, the thing I found particularly interesting was the talk about the value of the tax deduction for that interest.

Case in point, one neighbor raised the notion of accelerating his mortgage payments (by adding a meaningful amount to each monthly installment) so his own high-priced debt could be retired significantly ahead of schedule. Several neighbors ridiculed his idea. “That makes no sense,” one said. “Why would you give up the tax deduction?”

Fast forward to today.

Mortgage rates have been so low for so long that opinions on prepaying debts are as divided now as they were then, for the opposite reason. Some advocate for keeping this remarkably low-rate financing in place — even when the borrower has the wherewithal to pay off his loan — while others believe less is more when it comes to debt.

The financial management rule of thumb on debt is straightforward. After adjusting for taxes, if the interest rate on the loan that you’re contemplating is less than what you’re certain that you will be able to safely and reliably earn over a comparable term, it makes sense to borrow the money. But if the loan rate is higher than what you’re certain you can safely and reliably earn on your money — and provided you have the resources to do so — you should probably pay cash for your purchase.

In the case of residential mortgage financing, the rationale behind this thinking is the fact that, at the federal level, ordinary interest that’s earned is taxed at the same rate as the ordinary interest that’s paid.

Of course, that argument is muddied up when the earned interest is exempt from federal taxes (such as in the case of municipal debt) or taxed at a lower rate (as in the case of capital gains).

All that said, there are a few more things to take into account.

First, I am being very deliberate when I use the words certain, safely and reliably. Whatever the duration of the debt you either have in place or are contemplating, the critical question is whether the prospective investment will always pay out at a higher rate, come hell or high water.

The only financial instrument I can think of that passes this test is for U.S. government-backed debt. The last time I looked, 30-year Treasury Notes yielded 2.56% versus 3.35% for the average 30-year fixed-term mortgage (2.51%, net of a 25% average weighted income tax rate).

In other words, flip a coin.

The second matter to take into account is your financial resources. Are you flush enough to be able to part with a chunk of your cash — either to pay off your existing debt or to fund the new purchase — without potentially leaving yourself short in the event of an emergency?

The third thing to think about is related to the second. Will this new borrowing put a crimp in your budget? Said differently, do you have enough cash flow to cover the added expenditure and still leave yourself with enough of a cushion, just in case? (Your credit impacts the terms and conditions you may qualify for on a mortgage. You can get an idea of where yours currently stands by viewing a free summary of your credit report on Credit.com.)

Reversals of fortune are swift, as those who suffered job losses and earnings diminish following the 2008 crash can attest. And the plain truth is that not everyone’s earnings are represented by an unbroken, positive trajectory over an extended period. For many, that line is sawtooth — a mixture of forward and backward steps (hopefully more of the former).

This last point brings to mind advice from a business acquaintance of my father’s when I was still in college. No, it wasn’t plastics. Rather, he said something along the lines of, “The secret of life is not to ratchet up your standard of living to whatever salary you happen to be earning at the moment.”

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