Myth: Keeping Your Mortgage Will Save You Money in Taxes (January 2012)

By Professor Rick Ulivi, Ph.D.

I constantly hear that people don’t want to pay off their mortgages, because they believe that keeping them is a good way to reduce their income taxes.  This can be an erroneous way of thinking, and it reminds me of the old adage about being “penny wise but pound foolish.”  Let me explain.

Should you pay off your mortgage or not?  First, it depends on whether you have the savings to do so.  If you don’t, you can’t, so the question is moot.  Next, let’s assume you do have the money.  Do you have better things to do with it?  If you do, you may not want to pay off your mortgage.  If you don't, the decision to keep your mortgage should never be based on presumed tax advantages, because it is a very expensive way to get a tax deduction.

Let’s review the situation in which you have the money to pay off the mortgage.  Let’s assume you have $400,000 in a savings account or in stocks, but you also have a mortgage for the same amount with 5% interest, and 25 years to go until it is all paid off.  What would a smart investor do?  Pay the mortgage off or not?  If he can make an investment that will earn MORE than the interest cost of the mortgage, he should NOT pay off his mortgage.  That’s because he will be making more on his investment than he is paying on his mortgage.  In the example I used, this is like borrowing from the bank at 5% to invest at a higher rate of return.  The homeowner pockets the difference, which should make him very happy!

On the other hand, if you have the money and don’t have ways to earn more than the interest on the mortgage, should you pay it off?  YES!  But, the contrary argument is that, if you pay it off, you won’t be able to deduct the mortgage interest expense, so your taxes will be higher than if you kept the mortgage. Right?  While true, this argument overlooks how much you will be paying for the tax deduction.  Most likely you will be paying a price three to four times greater than what you save in taxes, so that makes no sense at all.  Look at it this way.  I assumed you were paying 5% interest on your mortgage, and, if you are not a Romney type who gets away with paying 15%, let’s imagine that your combined federal and state marginal tax bracket is 33%.  How much will you save in taxes?  You will save one third of the 5% interest or 1.65%.  Put another way, you are saving 1.65% by paying 5%.  Got it?  That’s being penny wise and pound foolish.  You are paying $5 to save $1.65.  At that rate, you will end up in the poor house very quickly.

So, why do smart guys like me have a mortgage?  In my particular case, because I don’t have the cash with which to pay it off.  I wish I did!  However, if I had the cash, and I felt confident that I could make an investment that paid me more than 5%, GUARANTEED for 25 or so years, I might make the investment, and keep my mortgage.  However, at my stage in life—I’m 62—I am more interested in cash flow than rate of return.  So, even though I might have the cash and a great investment waiting for me, I may prefer to pay off my mortgage because it would improve my monthly cash flow.  After all, you can spend cash but you cannot spend rate of return.

In sum, if you have the cash or equivalents that match what you owe on your mortgage, and don’t have great alternatives for that cash, pay off the mortgage. Forget about the so-called tax benefits of having a mortgage. It’s ruinous thinking.

As usual, if you need help with your retirement planning or with investing, or if you have questions about whether or not to pay off your mortgage, give me a call at 714-771-6000 or just reply to this email.