 Mortgage
interest deduction not always relevant
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 Dear
Dr. Don,
Regarding your advice on whether or not to pay off the $190,000
mortgage at 5.375 percent, asked by Matt
Mutual: You factor in the mortgage tax deduction in your computations,
but fail to mention the standard deduction of $10,300, which is
just above the interest paid on the full amount, which of course
would decline as the principal is repaid.
There are probably other itemized deductions, but in the simple example provided, I think the mortgage interest deduction should be ignored based upon that mortgage amount. You also failed to mention that paying off the mortgage is a guaranteed savings of 5.375 percent, while alternatively investing the money has no guarantee on the return, not to mention all of the funds being at risk.
I look forward to your column, and normally agree
with you, (and am one of those that think paying off the mortgage
ASAP is the way to go), but think your advice on this one missed
some key points.
-- Mark Soff
 Dear
Mark,
You've made an important point in analyzing the decision whether
to prepay a mortgage. The after-tax cost of the mortgage debt is
only relevant if you can use the mortgage interest deduction on
your taxes. Even if you can use the mortgage interest deduction,
the marginal increase in your deductions over the standard deduction
is the relevant measure for tax savings.
I went back and reviewed my response to Matt Mutual.
One thing that may not be clear from the table is that Matt is almost
$50,000 ahead by not paying off the mortgage, before considering
any impact on the mortgage interest deduction. If my scenario concerning
the mortgage interest deduction is realistic, then he's $156,000
ahead.
Yes, you know exactly what you're saving when you
prepay the mortgage, but the assumption is that the monthly mortgage
payment will then be invested. Conservative investors, putting their
money in CDs, can earn between 5 percent and 6 percent pretax, which
is 3.785 percent to 4.5 percent after tax.
If they can't use the mortgage interest deduction,
and they're paying 5.375 percent on their mortgage, like Matt is,
then it makes sense to prepay the mortgage. But Matt isn't that
investor. He's investing in mutual funds that can, depending on
how they're invested, expect to earn higher returns on an after-tax
basis than the mortgage.
An individual's tolerance for risk will influence
which decision is right for him or her. That's why they call it
personal finance. I'll stand by my advice to Matt, which concluded
with, "In general, if you expect your investments to earn more
after-tax than your mortgage costs you on an after-tax basis; you
should keep the mortgage and stay invested. Very conservative investors
often have a hard time meeting that hurdle, and prepayment looks
like a more attractive option to them."
Your point that the effective after-tax interest rate on the mortgage varies depending on the individual's ability to use the mortgage interest deduction is a good one. Thank you for writing in with it.
To ask a question of Dr. Don, go to the "Ask
the Experts" page and select one of these topics: "financing
a home," "saving & investing" or "money."
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