By Krista McBeath, McBeath Financial Group
Many Americans dream of owning their home outright. Paying a mortgage each month can be a burden and most likely tops your financial to-do list. Aside from owning your home, you most likely have other financial goals, such as investing in your retirement, your child’s education expenses, or whether you should use your savings to pay off your mortgage. Which goal should you decide to contribute your extra cash towards?
Mortgage payoff: evaluating the opportunity cost
The opportunity cost is weighing what you’ll gain financially by choosing one option against what you’ll give up. By making extra payments towards your mortgage, it is clear that you will be gaining financial ground. However, you still have to consider what you could be giving up by not exploring investing opportunities that could earn you more profits.
You will need to start by looking at the after-tax rate of return you can expect from prepaying your mortgage. If your mortgage interest rate is four percent, and you are in the 25 percent tax bracket, your after-tax cost would be three percent (assuming you are able to deduct your mortgage interest). To calculate your after-tax cost we take one, minus your tax bracket, and multiply that by your interest rate. (1-.25) = .75; .75 x .4% = 3%. Now consider this: could you receive a higher after-tax return if you invested that money instead of prepaying your mortgage?
While determining the best decision for you, keep in mind that the rate of return you’ll receive is directly related to the investments you choose. Take into account that the investments with the potential for higher returns will expose you to more risk.
Other points to consider
Aside from evaluating the opportunity cost, you should also consider the following list of questions:
- What’s the interest rate for your mortgage? The lower the rate, the greater the potential to receive a better return through investing.
- Is there a prepayment penalty tied to your mortgage? Although most don’t, be sure to check before making extra payments!
- Do you plan to stay in your home long-term? If you plan to move, there is less value in putting more money toward your mortgage.
- Do you have the discipline to invest your cash and not spend it? If not, then the best decision is to make payments to your mortgage.
- If you have unexpected expenses, do you have an emergency account to cover the costs? If you are forced to borrow money at a higher interest rate to cover unexpected expenses, it does not make sense to make extra mortgage payments.
- What is your debt comfort level? If you constantly worry about how much money you owe, give yourself the emotional benefit of paying extra on your mortgage payments.
- Do you have high balances on credit cards or personal loans? The interest rate is not tax-deductible on consumer debt, so it’s best to pay off those debts first.
- Are you paying mortgage insurance? If so, paying extra toward your mortgage until you’ve gained 20 percent equity is worth it.
- Once you have 20 percent equity, you may be able to cancel the PMI.
- If you prepay your mortgage, how will that affect your tax situation? Depending on how many years into your mortgage, prepaying could affect your ability to itemize deductions.
- Have you saved enough for retirement? Prepaying your mortgage may not be the best plan if you haven’t maximized your retirement savings plan.
- When do you reach retirement, or when do your children go off to college? The longer the timeframe, the more time you to invest and potentially grow your money.
- Do you have an emergency savings? In an emergency, it will be nearly impossible to access your home’s equity.
The middle ground
There is no reason you can’t invest for an important goal and pay down your mortgage simultaneously. You can do this by simply allocating part of your available cash toward one goal and putting the rest toward the other. No matter what you decide now, you can re-prioritize your goals later to keep up with changes to your circumstances, market conditions, and interest rates.
Krista McBeath is the founder and president of McBeath Financial Group in Normal. The firm covers all areas of financial management, specializing in retirement and financial planning solutions. For more information, you may call 309-808-2224, e-mail Krista@mcbeathfinancial.com, or visit their website at www.McBeathFinancialGroup.com.
Fee-based financial planning and investment advisory services are offered by McBeath Financial Group, a Registered Investment Advisor in the State of Illinois. Tax preparation and insurance products are offered through McBeath Tax and Financial Services, LLC. McBeath Financial Group and McBeath Tax and Financial Services, LLC.
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