Paying Down Mortgage Debt to Save on Interest Adds Up to a Bad Deal

The idea of paying down your existing 30-year mortgage is receiving much attention these days. We see it promoted by direct mail, discussed in advice columns and espoused in advertisements.

The emphasis is always on how much interest you’ll save over the life of your mortgage.

I think paying down mortgage debt is usually a bad idea. If a client were to ask me, “What long-term investment can you recommend that guarantees me a poor return and almost no liquidity over the next 20 odd years?” Paying down your mortgage would be my answer.

If you undertake such a pay-down plan, you are, in effect, making an investment with an almost guaranteed low yield (it’s guaranteed as long as your tax bracket remains the same) and with poor liquidity.

As an example, let’s assume your mortgage loan interest rate is 8.5% and you’re in the 28% federal and 9.3% state tax brackets. Your actual interest cost (net, out of pocket) is reduced to 5.5% from 8.5% because you can deduct mortgage interest expense on both your federal and state tax returns.

So the net effect of paying down your mortgage is that you are making a long-term investment that returns you a 5.55% annual return. In the long-term investment arena, returns like that are all but laughable.

As you can see, the deductibility of mortgage interest expense is a very great benefit, and that the more mortgage debt you pay off, the less benefit you get. It seems to me that any plan that eliminates a benefit has some problems.

Besides its poor return, let’s look at the liquidity aspect of paying down your mortgage. Suppose you start with a $200,000, 30-year fixed, 8.5% loan and make extra payments to reduce the period of the loan. A biweekly payment of half your regular monthly payment will pay off this loan in 22 years and six months.

What happens, however, when after 20 years of sticking to the pay-down plan, your employer goes bankrupt, you lose your job and have no prospects for work? You still have an outstanding mortgage balance of $42,325. While that is $80,351 less than you would have had without the pay-down plan, you still have a big problem.

Now, not only can you not make any extra payments, you’re having one heck of a time coming up with your regular $1,537.83 mortgage payment. And although you’ve faithfully made extra payments for 20 years, the lender doesn’t care. They require you to continue your regular payment or they’ll declare your loan in default.

Because you have substantial equity, you look for an equity line of credit. But because of your present job status, you encounter only exorbitant second trust deed loan rates. About this time you begin to wonder about your pay-down decision 20 years earlier. However, if you are forced to sell, you will have $80,351 more equity.

Now let’s see what happens if, instead of paying down your mortgage, you invest those same dollars in something else. We’ll just have time here to study two alternatives.

First, let’s consider a flexible, deferred annuity paying a conservative 7.5%, a full one percentage point lower than your mortgage rate. (For our example, I assume President Bush’s recommendation to eliminate the tax deferral for annuities will fail.) It turns out after 20 years you would accumulate an annuity balance of $98,648 before taxes. After taxes, if you withdrew the entire amount, you would net $81,065, $713 more than the pay-down plan would have benefited you by its increased equity.

My point is that you have done about the same as with the pay-down scheme, but with total liquidity, using a conservative annuity investment.

Of course, you don’t have to cash in the annuity. Your entire before-tax amount could be annuitized to help with paying the remaining 10 years of payments. Your annuity payments would be partly taxable, but you could deduct the interest portion of your remaining mortgage payments. Remember also you should be in a lower tax bracket because you now have no employment income. Instead, you could simply withdraw funds as needed from your annuity without annuitizing, leaving the account to grow tax deferred.

Now let’s see what would happen if instead of investing in the pay-down plan, you choose a high-quality, conservative, growth and income mutual fund.

For this hypothetical example, I used actual results of a fund that has been around for more than 30 years. This fund’s average annual returns over every 20-year period in the preceding 30 years (there are 10 such periods), ranged from a low of 11.58% to a high of 15.27%, with a median of 14.52%. If we consider income taxes (at the same 34.7% rate every year) the worst return drops to 8.51%, the median to 10.72%, and the best return to 11.95%.

Using these after-tax annual returns, our net investment balances after 20 years would have been $88,640 using the worst return, $142,189 using the median return and $164,875 using the best return. Even the worst 20-year performance of the mutual fund is better than the $80,351 benefit of the pay-down. And the median and best performances beat the pay-down plan by more than $60,000 and $80,000, respectively.

Investing your extra dollars in a growth and income mutual fund, instead of an accelerated mortgage pay-down plan, should outperform that approach substantially, and with total liquidity.

But if stocks are too uncomfortable for you, even a conservative, tax-deferred flexible annuity should beat the pay-down strategy, and with much more liquidity.

In conclusion, paying down your existing 30-year mortgage is a poor choice compared to other investment choices. As long as you can deduct mortgage interest on your tax return, your net return is generally less than with other investments.