Gauging Your Mortgage

Here's what to keep in mind when deciding whether to pay off your mortgage.
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Note: In my Feb. 23 article, Six Tax Moves for $10,000, please be advised that when I was discussing credit card debt refinancing, I was referring to taking out a home equity loan or line of credit, the interest on which would be tax deductible in some cases. I apologize for any confusion.

Here's a question I get all the time: "I've run into a little extra cash, and my current income is taking care of things. Should I be paying off my mortgage?

Heck, every financial column you read talks about avoiding or getting out of debt, and how there's too much of it going around.

But that's consumer debt -- the typically high-cost kind used to fund all sorts of short-term purchases.

So a mortgage is debt, too, right? Yes, but it isn't necessarily bad debt. Here's what I tell people who ask me about paying off their mortgage: Don't, if you can do better with your money.

Sounds good in theory, but you still have the itch to host that mortgage-burning party and light the match. The question is, should you?

Turns out it's a complex, multisided financial choice with no cut-and-dried solution. While my simple answer is a good place to start, it really depends on your tolerance for debt, retirement vision, investing style, age, tax situation and even where you live.

In a moment, I'll give you my list of reasons whether to pay it off. But first, here's some background.

On one hand, a mortgage is cheap compared with almost any other source of personal capital, especially considering tax savings. A 6% mortgage effectively costs 3.9% after mortgage interest deductions for those in a combined 35% tax bracket.

On the other hand, paying off a mortgage is almost identical to buying a risk-free bond paying a rate equivalent to the mortgage rate. For many investors, particularly those already with other more-aggressive investments, this sounds pretty attractive.

On the other hand, paying off a mortgage is almost identical to buying a risk-free bond paying a rate equivalent to the mortgage rate. Your return is the interest you

save

by not making a payment. For many investors, particularly those already with other more-aggressive investments, this sounds pretty attractive.

I should note that mortgages aren't as cheap for those in lower brackets.

Some in less-expensive inland markets may not have enough mortgage interest to exceed the standard deduction ($10,700 married filing jointly). And taxes are not the only consideration -- spending an interest dollar just to save 35 tax cents never makes sense.

Here's the biggie: retirement. Obviously, having a mortgage adds a large expense burden during a time when every dollar must be built to last.

There can be a double tax whammy. Taxes must be paid on precious 401(k) or traditional IRA dollars withdrawn in retirement to service the mortgage, while the interest deduction may be worth little to nothing at low retirement income levels.

Still, according to the 2004

Federal Reserve

Survey of Consumer Finances, some 32% of all households reach age 65 still carrying a mortgage.

Paying off a mortgage used to fly in the face of financial flexibility. If you paid off the mortgage, it was like locking cash into a vault and throwing away the key. It wasn't coming out again until you sold the property.

Click here for the video version of this story from Jennifer Openshaw.

What if you had a big medical expense? A great investment opportunity?

It's not such a problem today with home equity lines of credit and relatively easy refinancing, although the money usually costs a little more.

I could go on, but a summary will be more helpful.

Why you should pay your mortgage off:

  • Debt-free peace of mind. You sleep better at night not worrying about debt.
  • Lifestyle/career options. You want to retire early or have some lifestyle flexibility not otherwise possible with a big mortgage obligation.
  • Retirement flexibility. Eliminating the mortgage allows you to check a big one off the retirement-needs list. And it sets you up for a reverse mortgage during retirement.
  • You're a cautious investor. Some prefer to keep the mortgage and invest spare cash for higher returns. If you don't think you can consistently beat the 6% implied return -- risk free -- then pay off the mortgage.
  • You have other investment capital. If you have plenty of other capital to chase higher returns in real estate, equity or other investments, paying off the mortgage could make sense.

Why you shouldn't pay your mortgage off:

  • Other bases aren't covered. Paying off a mortgage early is a bad idea if you haven't taken care of other financial needs, especially retirement plan contributions. Don't starve your 401(k) or forgo a company match just to pay off the mortgage.
  • You plan to move or sell. If you're going to sell your home in the next few years, why bother to pay it off? You may need the capital for a down payment on your next home.
  • Better investments elsewhere. Money tied up in a home is "dead" money; it really earns no return except the interest you'd save on a mortgage payment.
  • You face AMT. AMT knocks out a lot of deductions, including mortgage interest for equity lines and seconds. But your first mortgage used to acquire the home remains deductible even for AMT.

Bottom line: Paying off a mortgage is a good preparation step for retirement. But the younger you are, the more it makes sense to use the mortgage as cheap financing and build your nest egg in other ways.

If your nest-egg-building plans are otherwise on track, lighting that match can make a lot of sense. At the end of the day, it's dictated by your situation and personal preference.

Jennifer Openshaw, a passionate advocate for helping Americans improve their finances and build their personal fortunes, is CEO of

The Millionaire Zone and America Online's personal finance editor. In addition to appearing regularly on TV shows such as "Oprah" and "Good Morning America" and on CNN, Openshaw is host of ABC Radio's "Winning Advice" and serves as an adviser to some of America's top corporations. Her new book,

"The Millionaire Zone," will hit bookstores in April 2007.