Thoughts on Paying Extra Towards Mortgage Principal

Since I mentioned it during my recent net worth update, I’ve been thinking more about whether I should commit some additional funds to pay down the principal on my mortgage and reduce my interest paid.

There is already a good deal of discussion on this topic in my posts Why Paying Down Your Mortgage Early Can Be A Smart Investment and 10 Reasons You Should Never Pay Off Your Mortgage, but I’ve tried to summarize all the pertinent points into something more coherent below.

Other Higher Priorities?
If you have no emergency fund, high-interest credit card debt, or don’t have your IRAs/401ks maxed out, then you probably should focus on those things before worry about paying extra towards your mortgage.

What is your tax situation?
Next is the topic of tax-deductibility of mortgage interest. Everyone already gets the standard deduction, which in 2009 is $5,700 for singles, and $11,400 for married folks. Only the amount that your itemized deductions exceed this amount actually saves you money. If you have a $150,000 mortgage at 5%, your interest is only $7,500 per year (and decreasing in the future). If that’s your only deduction, you’re not getting any real tax benefit at all.

However, some people have a big cushion of deductions, like high property taxes, state income taxes, charitable contributions, etc. Some don’t. Some people are in high marginal tax brackets, where saving 35% (and soon maybe 40%) sounds really nice. Some are in the 15% or lower tax brackets. As for us, we are in a high marginal tax brackets, and pay a good deal of state income tax, so the deductibility is definitely in effect.

Comparing with other investment options
One major argument against paying extra towards a mortgage is that you can earn a better return elsewhere. Who cares about saving 6% interest annually when your money could be earning 10% somewhere else? As we’ve seen recently, stock market returns are not guaranteed, and also not without lots of heartburn. If anything, you should compare your mortgage interest with a high-quality bond or bank account interest. If you could have your cash earning 6%+ safely, then there’s a solid alternative.

Liquidity
Another argument against paying extra is that it is hard to access the equity in your house. You may not get a home equity line of credit, or it may be frozen later. However, if your alternative investments are in IRAs or 401k’s, then those aren’t exactly liquid either. Also, if you have an adequate cash cushion (as we do) and proper insurance, then liquidity will become a lesser concern.

Inflation hedge
A nice thing about mortgage payments is that if you have a fixed mortgage, the payment stays the same each month. Meanwhile, rents will increase with inflation. If inflation starts to rise significantly, you’ll be very happy to have a loan at 5-6%. A previous landlord told me his mortgage payment was $300 per month, while our rent was $1,100!

A possible strategy?
After all that, my idea is to simply look at the current yield of a comparable U.S. Treasury bond and compare it to my mortgage interest rate. If my mortgage interest rate is a lot higher than the bond rate, then I should pay extra towards the mortgage. Otherwise, if the Treasury rate is higher, then I should invest in bonds or bank accounts directly instead. If it’s close, stick with liquidity.

For example, say my mortgage rate is now 5.125% fixed, with 29 years left. The 30-year Treasury rate is currently about 3.7%. In 1990 or in other times of high inflation, a bond with the same maturity remaining would have been yielding more than 8%.

This way, I pay down the mortgage in times of low interest rates, and keep my inflation hedge during high interest rates. That means right now, for my situation, I should pay extra towards the mortgage. Am I missing anything? (Most likely! But please tell me what.)

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