The recent downturn in the economy has spurred financial scrutiny in personal spending and savings. Most families have taken a closer look at their income versus expenses as well as savings versus debt to see how they can weather the financial storm. Anytime an examination of personal finances arises, the question of paying off the home mortgage seems to pop up. While the theory of debt elimination is good, understanding how a home mortgage can impact a personal financial plan is needed. To better understand the pros and cons of mortgage reduction we must take a closer look at debt.
Good Debt Versus Bad Debt
Some financial pundits argue that all debt is evil and there is no such thing as good debt. I take exception to this thought and find it somewhat short-sided. Some debt is bad, and I call this bad debt consumer debt, which includes personal loans, auto loans and revolving debt (credit cards). Consumer debt usually carriers a high interest rate and offers no tax benefits. The debt that I classify as good debt is mortgage debt and student loans. Both mortgage debt and student loans have tax advantages. While not all taxpayers can take advantage of the student loan interest deduction, I find an investment in one’s education and future certainly justifiable.
Understanding Mortgage Debt
A mortgage is a debt secured by a personal residence, and that residence is an appreciating property (at least over the long term). Since a home will increase in value over time, mortgage companies allow long term debt against this property. A 30-year mortgage is the most common example.
The IRS gives homeowners a break by allowing a mortgage interest deduction for interest paid on a home mortgage. Obviously, there are rules and restrictions, but the majority of homeowners have allowable mortgage interest. This deductible mortgage interest effectively reduces the taxpayer’s true mortgage expense. For example, a taxpayer in the 25% tax bracket with a 5.5% 30 year fixed mortgage will effectively hold an after-tax interest rate of roughly 4.4% (this number will vary based on the calculation and year of the loan).
There is another benefit to holding long-term mortgage debt that most people do not realize. A long-term fixed-rate mortgage provides a nice inflationary hedge. Sound confusing? Here’s an easy way to understand this concept. A homeowner will pay tomorrow’s mortgage payment in today’s dollars. Simply put, the mortgage payment 10, 20 or 25 years in the future will remain the same (barring escrow payments). The home increases in value, but the mortgage payment does not.
Why Have a Mortgage?
Besides tax deductibility and the inflationary protection, a properly valued home and properly sized mortgage can create balance. Buying the right size home and carrying the right size mortgage is a vital piece of a balanced financial puzzle. If a homeowner pays off a mortgage and draws down cash to do so, a liability can be created. A rich house and cash poor homeowner who owns their home outright is not balanced.
Retaining cash and leveraging that cash can be quite powerful as well. I often see prospective clients that don’t fully max out their retirement plans or IRAs but are paying extra money every month towards mortgage reduction. This move does not grow wealth. Imagine the scenario where a couple is paying an extra $500 a month to their mortgage. If that couple is not maxing out IRAs or 401ks, they could put the $500 a month towards their retirement. If they are in the 25% tax bracket, the $6,000 contribution for the year would reduce their tax bill at least $1500, and this is not factoring state taxes. That’s a 25% return on investments before the money is invested. Once the money is invested it will grow and should outpace the after-tax effective mortgage rate in the long run. That’s leverage!
A Few Things to Remember
Once additional money is paid towards a mortgage, it is gone. The only way to get that money back is to refinance, open a home equity line of credit or sell your home. All three of these have fees and costs involved. While a home is somewhat marketable, it is not an asset that can be sold quickly and efficiently. Any money put towards principle reduction will be tied up and difficult to utilize.
Personal financial planning is similar to Newton’s Third Law: “For every action there is an equal and opposite reaction.” Every financial action taken in one specific area will affect another. This is why the topic of mortgage reduction or elimination should only be discussed from a comprehensive viewpoint. The above examples illustrate how a mortgage can impact, either positively or negatively, many other financial areas, such as taxes, cash flow and even retirement.
Even though there are many positive attributes to having the right size mortgage, there must be parameters. Taking the stance that mortgage debt is a plus does not one give free rein to overspend! The decision of homeownership should be carefully considered in the context of the whole financial picture.
While we tighten our financial belts and march forward through the economic downturn, it is wise to fully understand all financial decisions and how those decisions can impact our financial wellness. The mortgage reduction question is one that requires careful consideration. For all the reasons discussed above, a rush to reduce a mortgage balance could be the wrong choice. A comprehensive understanding of a home mortgage is essential before any steps are taken to either increase or reduce mortgage debt.