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Personal Financial Planning - Where the Home Mortgage Fits In

By  Mar 25, 2010

Topics: Finance & Investing

Even with the best and most comprehensive investment plan, will you be able to retire if you are carrying a large home mortgage? The American Dream used to be buying a home. In the future, it is more likely that the American Dream will be to own a home without any debt.

With mortgage acceleration, a home mortgage spanning 30 years can be cut in half and paid off more quickly. This not only reduces debt; it also drastically cuts interest expenses. In the typical 30-year mortgage, the debt is only one-half paid off after 20 years. So putting a little extra each month toward principal goes a long way to reducing the debt. And the earlier in the 30-year term the acceleration program begins, the greater the benefit.

Some people believe pre-paying the mortgage is a bad idea, because it reduces the deductions allowed on the individual tax return. This argument doesn’t make sense. For example, if you prepay $1,000 this year and that cuts your taxes by 40%, or $400, you are still out $600. It would be more profitable to pay down your mortgage and get a compound return equal to the rate you’re paying the bank.

For example, if your current rate is 5%, every pre-payment you make today reduces interest through the rest of your mortgage term, at a compound 5% interest every year. This is a smart investment, with the return coming in the form of reduced interest rather than taxable net profits. For example, if your 30-year mortgage is around $100,000, adding in an extra $250 per month in pre-payment of principal cuts your repayment term in half, enabling you to get debt-free in 15 years. That happens because the balance declines for every dollar prepaid, not only this year, but in every additional year as well. This is the real benefit of compound interest and it works for you in repaying debt just as it does in making deposits into a mutual fund.

Another argument is that you’re better off keeping your mortgage to get the deduction, and investing cash elsewhere. But if your outside investments are taxable, the profits offset your mortgage deduction. This argument is also provably false.

Finally, you need to compare risks. Investing money elsewhere always involves a degree of market risk. But prepaying your home has no market risk at all. It is an investment in your equity and reduced cost of your home. So the argument that you need to invest elsewhere is false because it is a suggestion to take more risk for little or no net benefit; in fact, it involves increased market risks.

It comes down to common sense. Paying your mortgage off within the next six to 10 years enables you to gain improved financial security. It provides a safe and secure lifestyle and in the future, an equally secure future. Home equity has been treated as a piggy bank in the recent past, with dire consequences. As homeowners realize that their home equity needs to be protected and increased, more people with realize the truth: the real American Dream is to own your home without also carrying a long-term mortgage.