I Have the Money

You came across some extra cash and now you’re faced with a dilemma. Should you use it to pay down on your home mortgage – or should you invest it?

If you were to ask your buddies on the golf course, they would probably tell you to keep your home mortgage because you can deduct the interest on your taxes. And your investment advisor would probably agree. After all, investing it will produce a higher rate of return than the mortgage interest you pay.

So there you have it, right? Well, not so fast.

You should consider other factors before deciding. It might actually be more beneficial to reduce your home mortgage. And when you get right down to it, it depends on your unique situation – there is no cookie cutter answer that will work for everyone.

Personal Preference

Some people just sleep better at night knowing they own their home debt-free. That feeling of comfort may tip the scales in favor of paying off the mortgage, especially if tax and investment factors offer you no real benefit.

On the flip side, maybe you like the comfort of having extra money in investments in case of an emergency. In which case, having unrestricted marketable securities readily available may be more attractive. But it may not always be advantageous to liquidate those investments in time of need.

Impact on Taxes

Despite what most people think, there is generally a tax disadvantage to keeping your higher mortgage and investing the funds.

The home mortgage interest deduction is a “below the line” itemized deduction. That means the deduction happens after your adjusted growth income, or AGI, is calculated, which is not as beneficial as those deductions directly to your gross income. Plus, home mortgage interest deductions are subject to the following limitations:

  • Most states with an income tax, including Ohio, don’t allow you to deduct home mortgage interest.
  • Many people don’t have enough deductions to itemize. Or they lose part of their deductions until they reach the standard deduction amount.
  • The itemized deductions don’t reduce your AGI. AGI affects many of the phase-in and phase-out provisions of the tax code, or those provisions that kick in or no longer apply at certain income levels. Examples include taxability of Social Security benefits, loss of exemption amounts, certain itemized deductions and traditional or Roth IRA contributions.

There are limits on the interest you can deduct for the acquisition of a home and home equity debt.

These limitations are further impacted if you generate additional taxable income, which also affects the phase-in and phase-out provisions described above. You end up compounding the problem and may pay more tax in the long run.

The type of investment you make also affects your tax liability. It’s important to compare mortgage rates to current fixed income rates. If the mortgage rate is low, that may justify investing the money in a fixed income investment with a higher rate. However, to make up for the tax disadvantage, the fixed income investment rate must exceed the mortgage rate by enough to make up for the difference.

You could also invest in tax-exempt obligations which would provide non taxable income for federal and state purposes. However, the mortgage interest rate, even after receiving a tax deduction, will generally still be higher than the interest rate generated by the investment. This is typically true even with high tax bracket taxpayers.

There can certainly be a net tax benefit if the money is invested in equities. In fact, there may be no additional tax obligation with an investment in growth stock. Further, any dividends and future capital gains are currently taxed at a preferential rate.

Keep Your Long-Term Plan in Mind

Investment advisors and financial planners often recommend investing in equities since the rates of return are generally higher than fixed income investments. However, you have to decide how much personal risk you are willing to take.

For example, the average long-term return on large cap stocks exceeds 12 percent. This is much higher than the long-term average return on fixed income investments. But this only makes sense if you are willing to accept the risk associated with increasing the percentage of equities in your portfolio while also retaining the risk of having the higher mortgage.

Or, you may have an opportunity to make tax deferred investments and maybe even get a deduction or exclusion. You might be able to justify investing the money by increasing your elected deferral or contributions to qualified retirement plans or an IRA. In this scenario, you could benefit from the current tax savings and the deferral of tax on the growth. But you must be comfortable with the risk of having the mortgage while knowing these investment funds are generally not available without penalty until retirement.

Regardless of your decision, whatever you choose to do should fit into your overall retirement, investment and wealth accumulation plan. Most advisors suggest having part of a portfolio allocated to fixed income investments. Paying down the mortgage could, and probably should, be looked at as an alternative to fixed income investments in the portfolio.

So, the decision is a complicated one. There is no one-size-fits-all answer. Review all the tax, risk and investment factors before you make a decision, and consult with your advisor for more help.

This article was originally published in The Rea Report, a Rea & Associates print publication, Fall 2009

Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.