Accretive On: Should I Pay Off My Mortgage?

May 22, 2019

Markets are hitting all-time highs and you’ve been saving extra cash each month. You look at your budget and personal balance sheet, and one item stands out in both – your mortgage. Many people are asking themselves; is now a good time to pay it off?  

For some, this question is a closet market timing question. They believe markets have reached a top and want a reason to sell. For others, it’s a peace of mind question; people are trained to think less debt is good and the goal is to be mortgage free. We’ll address both of those lines of thinking.

The interest rate on your mortgage is simply a hurdle rate for your cash and investments. If you can earn more on your cash and investments than your after-tax mortgage rate then mathematically you’re better off carrying the mortgage. This raises two questions – what do I mean by after-tax mortgage rate, and how do you know whether cash and investments will beat that hurdle?

If you don’t itemize your deductions then the after-tax mortgage rate is the stated rate. However, if you itemize your deductions then you are still getting a tax deduction on the interest paid on qualified residence loans of up to $1,000,000 if you took out the loan before 2018 and $750,000 if you took it out after the 2018 Tax Cut and Jobs Act. For example, if you have a mortgage of $500,000 at a rate of 4% and you’re in the 22% Federal tax bracket then your after-tax mortgage rate is 3.12% because you’re getting a deduction on the interest paid.

Now you know the hurdle rate for your cash and investments. Can you exceed it? Your mortgage is a going to be a long term (15 – 30 year) liability. First, it’s beneficial to have a historical perspective on what 10-year returns were on a globally diversified 60% equity/40% fixed income portfolio. For our example, we use the MSCI All Country World Index TR for equities and Bloomberg US Aggregate Total Return Index for bonds, rebalancing quarterly. During the 10-years ending April 30, 2019, this type of portfolio generated an annualized return of approximately 8.13%.  (Source: YCharts)

Historical returns would exceed today’s mortgage hurdle rates regardless of whether one itemizes or not. There are reasons to believe that prospective returns over the next ten years may be lower than the last 10 years, but subsequent returns would need to decline significantly for an investor with moderate risk tolerance to not exceed the mortgage hurdle rate.  

While there is certainty that comes from paying off a mortgage, you need to keep perspective that the cost of borrowing for a mortgage for the next 15-30 years continues to be very inexpensive, especially relative to the alternative uses for the cash. This continues to be true even as the market continues to hit new highs. If you’re retiring or already in retirement and the monthly payment is painful for you then consider talking to your advisor about setting up recurring monthly distributions from your portfolio instead of taking out a lump sum at once to pay off the balance of the mortgage. Cash flow planning is a crucial part of any retirement plan and is an analysis Accretive offers to our clients.  

If you have questions about your situation then we’d welcome a conversation with you on how we can help.  

Financial Planning

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