To Pre-Pay or Not To Pre-Pay
With so much economic uncertainty going on both here and abroad, it's understandable that people are worried about the future. Some may even want to minimize their debt as much as possible. If you've been thinking about pre-paying your mortgage or taking on an accelerated amortized loan (i.e. 15 year fixed), read on for some important information.
The Tax Implications
The first thing to understand is that mortgage interest is tax deductible. This means that, for example, people in a 25% federal income tax bracket (which is the most common bracket that people are in) essentially receive a 25% coupon off the cost of their mortgage from the government.
Let's look at the following example. Say you have a $200,000 mortgage at 3.5%. Your annual mortgage interest cost would be $7,000. That $7,000 can then be used to reduce your taxable income, saving you $7,000 of taxable income!
If, like most people, you are in the 25% federal tax bracket, you pay $1,750 less in income taxes now because of that. So the net $7,000 minus $1,750 makes the true net after-tax cost for the mortgage only $5,250. That $5,250 is your 2.625% net-effective after-tax rate to borrow money.
The next important point to consider is this: If you could borrow money over 30 years at a net cost of only 2.625%, would you rush to pay it off? The answer will be (and should be) no!
Here is why. Long-term inflation (the costs of goods and services all around us) has averaged an annual increase of 3.2% over the last 30 years. So if you are borrowing money and paying only 2.625%, you are borrowing less then the current long-term average of inflation!
This means that your mortgage payment will actually get cheaper over time and feel less of a burden. As the price of everything around you is rising at a pace of 3.2%, your mortgage is fixed for 30 years at 2.625% in our example! Another important point that most people forget is that mortgage payments get cheaper over time.
Pre-Pay Your 401(k)
Now the real question is: If you don't pre-pay your mortgage, what should you do with any discretionary income
One great idea is investing it for your retirement by investing into your company's 401(k) plan at work. The key to growing wealth is to get as much pre-taxed money into your 401(k) where it can compound and grow tax-free until you need that money in retirement. Plus many employers pay you additional money to invest into your 401(k). So not doing so is refusing free money!
Think of it this way: Every dollar you don't put into your 401(k) will actually only end up being 70 cents–or possibly even less–due to income taxes. That's because most people lose 30% of their income to income taxes (25% federal and 5% state, or more in some state and federal tax brackets). The highest federal income tax bracket is 35% and in California, for example, the highest state income tax bracket is 10%. So someone in the highest income tax brackets in California would only have 55 cents left of the dollar that was not deposited into his or her 401(k).
The Bottom Line
Making the right decisions about your mortgage and investing for your retirement can feel overwhelming, but they don't have to. If you have any questions about your personal situation, contact me for a no obligation consultation.
If you have any questions at all about how the news here or abroad might impact your personal situation, you can contact Gary Umholtz at RPM Mortgage (707) 343-9510.