Early mortgage payoff isn't always a bad idea

The Baltimore Sun

Frances of Ellicott City poses one of the most frequent questions financial planners get. Should she pay off her mortgage early?

Frances reads financial magazines that say it's a mistake to prepay when you could be earning more with it in the stock market than what you pay in interest.

"I get that," she says in an e-mail. "But in these days of crazy market swings, it feels much better to see a declining balance on my mortgage than to see the shares that I bought last week decrease in value this week!!! I seriously get excited by seeing the payoff number on my mortgage shrink - much so more than a shopping trip even! So how bad can it be to pay off your mortgage early in these turbulent times?"

Loss of deduction

Frances says her husband worries about losing the mortgage interest deduction on their taxes. They're four years into a 30-year loan and the couple, both in their 40s, have no other debt. Frances says she and her husband max out their contributions to their 401(k)s and invest outside those accounts for retirement and college for their small children.

It's a case of numbers versus psychology. Only Frances and her husband can decide what's right for them.

California financial planner Phil Cook argues that Frances should put her emotions aside and look at the numbers. The interest rate on the couple's mortgage is 5.33 percent. That's essentially her annual return if she pays off her mortgage early.

But the returns on the stock market - whether looking over the past three, five, 10 or 15 years - are all higher than the mortgage rate, he says. If Frances wants to build up her net worth, Cook says, the stock market is the place.

"The reader is concentrating on the short-term volatility of the market instead of the long-term returns of investing in the U.S. economy," he says.

Virginia financial planner Barry Glassman also points out that if Frances and her husband want to tap the equity of their home after paying off the house, they may not get an interest rate as low as they have now on their mortgage.

But Lutherville financial planner Nancy Bryant says one can't ignore the psychological benefit of paying down debt.

"Since this would provide you with a level of satisfaction that would improve the quality of your life, I say do it regardless of what the numbers tell you," she says.

As far as the tax deduction, Bryant says, "There is a tax benefit to having mortgage debt, but it isn't nearly as substantial as tax preparers and accountants make it out to be." Glassman adds that the tax deduction would continue shrinking until it disappeared anyway.

If Frances is stressed or losing sleep over the market, by all means she should put her extra dollars toward the mortgage, Glassman says.

'Happy medium'

But Bryant and Glassman also agree that Frances needs to get her husband on board with this plan. Maybe they can compromise.

"Find a happy medium where they both have their goals covered," Glassman says. The couple can invest in a mutual fund and pay off their mortgage more aggressively than their current schedule, he says.

Glassman adds that he hopes Frances' husband appreciates how lucky he is.

"Because her goal in life is not the handbag or the pair of shoes or a bigger house or jewelry. Her lifelong goal is financial stability and to pay off debt."

Cashing EE bonds

Vern of Ellicott City purchased EE savings bonds in the 1990s. He now wants to cash them in for his children's college education. By using the proceeds for college, he won't pay federal income tax on the interest that had been accruing on the bonds for years. But, he asks, how does he report this to the Internal Revenue Service?

Vern needs to fill out Form 8815 when he files his taxes.

For others who might hold Series EE or I bonds, it's good to remember that you can cash these in for college and get the tax break. You won't pay taxes on some or all of the interest accrued provided your adjusted gross income is less than $78,100 for single filers and $124,700 for joint filers. You also need to have been at least 24 when the bond was issued, so those receiving bonds as tiny tykes won't get this tax break later.

Questions? Comments? Write personal.finance@baltsun.com.

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