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Have the Urge to Own Your Home Free and Clear?

| September 06, 2016
Financial Planning

Yes. There is something psychologically satisfying about this, but that is one of the only few advantages. Don’t get me wrong. There are situations where paying down a mortgage makes perfect money sense. However, there is a good chance your situation is not one of these. A 2007 Fed study found that at least 38% of those who were making extra payments on their mortgage were “making the wrong choice.” These households would get back 11 to 17 cents more on the dollar by placing these extra dollars into a pre-tax employee sponsored retirement plan (e.g.) 401(k). This may not sound like a lot, but on the low end if you are applying an extra $100 a month to your home loan; this could mean you missed out on $132. So, why, exactly, is this?

  1. Borrowing money for your primary residence over the long-term is about the cheapest money you can borrow. Think about it. If you have a mortgage with a 4% annual interest rate and your retirement plan averages 8% over the long-haul, there this a 4% spread on your money.
  2. The interest on your home loan is tax-deductible if you itemize your deductions. If you are in the 25% tax bracket a 4% annual interest rate loan could really be only costing you 3%. In this case, the prior reason we explained just got bigger. You now have a 5% spread on your money.
  3. The dollars you place in a pre-tax employee sponsored retirement plan, like a 401(k), are not included in your taxable income. So let’s say you take that extra $100 a month and place this in your 401(k) instead of applying it to your home loan. If you are in the 25% tax bracket, you just saved yourself another $300 per year that would have been sent to Uncle Sam.
  4. Many pre-tax employee sponsored retirement plans have matching incentives. This means free money. For instance, one employer might match 50% of your contribution up to 6% of your income. So, if you make $100K a year this could mean a free $3,000 a year.

I also have some words of wisdom for those of you who are already maxing out your retirement plans. Don’t get the urge just yet. Make sure you have efficient emergency savings. This should be 3 to 6 months of income on hand. And don’t forget to protect everything else you are building. Make sure you have an efficient risk management plan in place. It would be absolutely ridiculous if you paid extra on your mortgage, but lost your home because you became disabled and did not have the proper insurance in place to provide you income.

Last, I have always said you don’t know what you don’t know. Be aware that there are mortgage-accelerator programs that have proved to be extremely successful that do not take away from your extra dollars, and I am not speaking of bi-weekly payment programs offered through your bank. We have worked with several business owners and home owners to shorten the time of their notes significantly. The key is these programs don’t knock on your front door. You have to ask, what do I not know?