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Where to put your savings… in the market or in your mortgage.

July 31, 2014

Where to put your savings… in the market or in your mortgage.

One of the most common questions I get from clients is, “If I have a little extra to save each month, should I use it to accelerate my mortgage payments or invest in the market?” First, I respond to the question with a question, “What is the rate of return you earn by paying down your mortgage…?”

Answer – It’s your mortgage’s interest rate less any savings generated in the form of itemized tax deductions. I like examples so I’ll show one here:

You have a $450,000 mortgage with a 4.50% fixed 30 year loan. You and your spouse have a combined top federal tax rate of 25%. Your rate of return paying down this debt is as follows:

4.50% X (1 – .25) = 3.38%

The next step is to evaluate your alternative… investing in the market. To keep it simple, the S&P 500 index has averaged a total annual return of ~7.6% in the last 10 years, a range including 2008, the second worst stock market year in U.S. history. Let’s assume that’s an after tax return of 6.5% (dating back to the 1970s, returns have actually been significantly better than this). So why would anyone take a 3.38% return accelerating the pay-off of debt when rates of return on the stock market are nearly 2X as large?

*** Stock market returns are highly variable whereas your return on debt is guaranteed.

I feel the ultimate decision should rest on three factors: (1) the length of time you plan to own your current home, (2) your top federal tax rate, (3) and the size of your loan balance.

(1) The longer you plan to hold an investment, the more value fluctuation you can absorb and the higher returns you can hope to achieve. The shorter the time horizon, the smaller capacity to withstand market shocks and the greater weight to be placed on safety of principal and guaranteed returns. So… the longer you plan to hold your house, the more time you have to let the cash you’ve invested in the market work. If you plan sell your house within the next 5 years, you’re probably better off taking the safe route earning your after-tax 3.38% return by accelerating mortgage payments rather than investing more in the market.

(2) From the formula above you can see, the higher your tax rate, the lower your return on the pay-down of debt. Just substitute 33% in the formula above and see how your return shrinks to just 3.01%.

(3) Finally, the size of your loan balance is what generates the total dollar ITEMIZED deduction. On small mortgages, the interest expense could be so minimal that you would still take the standard deduction on your tax return ($12,400 for married couples in 2014) instead of itemizing thereby making your mortgage interest deduction worthless. So… the larger the mortgage balance, the more valuable the interest deduction and the greater incentive to invest in the market over accelerating payments on your mortgage.

Note: this is the first of a series of financial planning blogs I’ll do. Please submit topics that would interest you and I’ll be happy to work them into the rotation. Thanks for reading!

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