Prepaying mortgage not a no-brainer
|  Dear
Dr. Don,
I have heard so many debates on paying off the mortgage versus
not paying off the mortgage, but to me it's a no-brainer. I want to pay off
my mortgage! Here's my plan: I have $40,900 as a principal balance and
about 20 years left on my mortgage. The total principal and interest each
month is $323.38.
According to the amortization
schedule I printed out, the total interest I would pay if I continue to pay
on this mortgage would be $35,038. Adding that to my principal, I would pay
a total of $75,938.76 over the next 20 years if I continue my loan.
If I pay off the loan now, I would be saving that $35,000 of interest, plus I
could contribute an additional $323/month to my 401(k) at work ...
which would also grow over the years, giving me, as far as I can see, a huge savings
that I would not have had if I hadn't paid off the mortgage. I realize there's
a tax write-off for mortgage payments, but it can't add up to the amount I'd have
saved at the end of those 20 years if I pay off my mortgage!
Do you agree? I'm no financial expert, but as I said, it seems to be a no-brainer
to me!
-- Deborah Decided
 Dear
Deborah,
What makes it a "no-brainer" in your case is that you're
going to prepay the mortgage and then use the money you would have
spent on the mortgage payment to make additional contributions to
your 401(k) plan. The tax advantages of that strategy make it easier
to justify prepaying your mortgage.
What's missing from your analysis is consideration of
how the $40,900 used to pay off your mortgage is invested. You
only look at how it generates interest savings and the ability to
invest the mortgage payment.
The $40,900 needed to pay off your mortgage, invested
over 20 years at an after-tax rate of return of 6 percent, will
grow to $135,387. The lost tax deductibility of the mortgage interest
does have a cost, assuming you can use it in calculating your income
taxes. I assumed that you could use it in calculating your
income taxes and estimate the value of investing that tax savings
over the 20-year period at 6 percent after-tax as about $20,000. So
combined, the value of not paying off the mortgage early and keeping
the $40,900 invested and taking the tax deduction has a future value
20 years from now of $155,387.
Since 401(k) contributions are made with
pretax dollars, an after-tax sum of $323 per month can buy more
than $323 per month in contributions to the 401(k)
plan. I'm going to assume that $323 per month buys you $430 per
month in 401(k) contributions at an 8 percent pretax
rate of return. That contribution stream is worth $253,279
(pretax) 20 years from now or $189,959 after taxes at 25 percent. If
your contributions are matched by your employer, the forecasted
results are even higher.
Without the extra $107 per month in contributions to
the 401(k) and the advantage of deferring taxes on
the additional 401(k) investment, the comparison would
be a lot tighter and not the "no-brainer" that you suggest.
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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