How to Determine if Paying Off Your Mortgage is the Right Move For You

The following is adapted from Financial Freedom Blueprint.

Have you ever wondered if you should pay off your mortgage? For decades the common wisdom has been to be debt-free before you retire. For many people this is a wise decision, but for others, not so much.

There is an increased sense of security when you are debt-free. Recently a high-net-worth individual who has significant wealth in liquid assets asked me this question because she was worried about the economy and world politics.?

She sat down with me and voiced her concern. She said, “I’m really feeling unsure about the economy. I’m seeing a lot of craziness in the world. I see governments that seem to be acting irrationally. I’m worried about war. I’m worried about the stock market going down and volatility going up. What if the Federal Reserve raises interest rates? I’m just not feeling secure even though I have some money and investments, so I want to know: should I pay my mortgage off?”

You may be better off financially to keep your mortgage when you retire, but you may not be able to sleep at night with the debt. There is a trade-off between economics and emotions to have a mortgage.

The Math Behind Your Decision

From a mathematical standpoint the decision is based on three primary factors:?

• interest rates
• your marginal tax rate?
• your risk profile

The interest rate on your loan combined with your tax rate determines your after-tax cost of mortgage debt. For most people, when mortgage rates are low, it generally does not make sense to pay off a mortgage. The converse is also true, when rates are high, it does make sense to pay off the mortgage. The higher your tax bracket, the lower your after-tax costs of debt because you are getting a tax break from deducting interest expense. Let’s go through the general procedure.

An intuitive way to solve the mortgage-payoff problem is to compare two projections of your net worth. The first scenario assumes you keep your mortgage, and the second scenario assumes you pay it off. Whichever projection gives you the highest net worth tells you which is better. Of course, this assumes you want to maximize your net worth. To answer this question, we generally recommend running a financial model that calculates the principal and interest payments month by month. This allows you to get a more accurate picture of the time-value of money and the use of your capital.

The Tax Impact Is Critical

It’s necessary to analyze the tax benefit that you’ll receive from being able to deduct your interest expense each year. When you have a mortgage, your interest payments may be deductible if you itemize your deductions. If you’re in a higher tax bracket, you get more tax benefits from a mortgage than if you are in a lower tax bracket. Keep in mind that if you pay off that mortgage, the tax benefit from deducting your interest goes away, so it’s critical to consider that tax benefit. Here are the steps to solve the mortgage-payoff challenge.

#1: Calculate the Net After-Tax Benefit from Not Having to Pay a Mortgage Anymore

When your mortgage is gone, the real long-term benefit is you don’t have to make payments any longer. On the other hand, you’re paying more taxes because you lost your interest tax deductions. The net after-tax benefit that you receive can be invested or spent. To find the economic benefit of this, we compound and reinvest the after-tax cash flow on a monthly basis. Of course, because you’re earning money on the reinvestment of funds over time, you have to pay some taxes on the reinvestment of earnings as well.

#2: Calculate the Net After-Tax Opportunity Loss from the Funds Used to Pay Off the Mortgage

Next, we answer the question, “Had I kept that money and invested it, how much would it have grown over time?” We turn our attention to the loss of earnings you will experience if you use a lump sum to pay off the mortgage. That money is no longer available to compound and grow. The economic value of this can be significant depending on your rate of return and the tax considerations. This is an opportunity loss from the investments that you’re foregoing, because you could have taken the money that you paid off the mortgage with and just kept it invested.

#3: Compare Your Numbers

We compare the number calculated from step one to that of step two. Which gives you a better net worth? Is the benefit from not having to pay the mortgage greater than the opportunity loss from your investments? When you run through the math month by month, you get a more accurate picture to see which choice is better. Generally speaking, if the after-tax rate of return on your investments is greater than the after-tax cost of your debt, you should not pay off your mortgage, and vice versa.

Another way to look at this situation is to use the following formula:

Net Benefit = Present Value You Get – Present Value You Give Up

In this case you get the benefit from no more mortgage payments, and you give up the investment earnings over time from the lump sum used to pay off the debt.

Reasons for Paying Off a Mortgage

We’ve talked about the reasons to not pay off a mortgage, so let’s discuss the reasons for paying it off. If your risk tolerance is low enough that your investment returns are likely to be below the after-tax cost of your mortgage, then you should pay off your mortgage.

To evaluate whether this applies to you, I recommend calculating the break-even return that your investments must earn to overcome the burden of having a mortgage. This is the rate of return that, if earned, would not give you a benefit or loss when compared to paying the mortgage off or not. In this case, the breakeven return is 4.82 percent. This assumes steady compounding with no volatility in returns.

In the real world, returns are variable and move up and down. It’s a good idea to perform a sophisticated analysis called a Monte Carlo simulation to estimate the probability of having a return lower than what is required to break even. I recommend getting Monte Carlo scenarios done for you with a financial advisor. This analysis should consider many different economic scenarios and ranges of returns.

In 2021’s environment, with the S&P 500’s dividend yield about 1.52 percent, you only have to have a relatively small growth rate in earnings and/or multiple expansions to overcome this relatively low hurdle rate, but there is no guarantee that an account will earn a return.

Whether or Not is Easily Calculable

When you do pay off the mortgage, one thing that’s really important is that you no longer have a steady payment that you have to plan for. If you’re living off your investments—you’re financially independent—you may have to make your investment portfolio a little less volatile so that you could fund a steady mortgage payment that must go out. This method generally lowers your expected return and may make it more advisable to pay off the mortgage.

Whether or not you should pay off your mortgage is a decision that can be easily calculated and determined using simple math and these three steps. It is important for your long-term finances to reach the most effective conclusion possible, and fortunately you now have the information you need to make an educated decision.

For more advice on whether you should pay off your debt, you can find Financial Freedom Blueprint on Amazon.

Louis B. Llanes is the founder of Wealthnet Investments, LLC, a fiduciary registered investment advisory firm. Prior to founding Wealthnet, Louis held several investment management positions, including senior portfolio manager for the US Bank Private Client Reserve, quantitative trader for a private fund, and investment consultant for Kemper Securities. Louis holds the Chartered Financial Analyst (CFA) and Chartered Market Technician (CMT) designations, an MBA from the University of Denver, and a BS in Finance from the University of Colorado. A contributing author of The Handbook of Risk, he wrote Financial Freedom Blueprint to help busy professionals enjoy the retirement they deserve as early as possible.