I Have Extra Money. Should I Pay My Mortgage Off Early?
“It’s a mistake to pay off your mortgage early,” says your financial advisor. “With rates this low, it makes no sense. And besides, the mortgage interest is tax deductible. Why would anybody want to put their money into their house?”
Too often, I come across families and individuals who have the means to make accelerated payments towards the balance of their mortgage, but are discouraged from doing so by one-sided, oversimplified advice such as the above (admittedly, the above is my own oversimplification of the oversimplified advice I am about to debunk). This is not to say that there is no wisdom keeping your mortgage as long as possible; for some people, it may make sense to hold onto their extra cash, and keep the mortgage going as long as possible. But for others- especially Muslim families who wish to avoid debt and interest- prioritizing paying off your mortgage makes a lot of sense.
Below are five points to consider before making your decision that may help you to reach a more balanced conclusion. In many cases, accelerated repayment of your mortgage is not nearly as foolish as your financial advisor may think, and indeed, may make a lot of financial sense for the average Muslim investor:
Interest is ALWAYS an expense…
These days, many people have mortgages at interest rates of 5% or lower. Because these mortgage rates are so low by historical standards, many financial advisors believe it is unnecessary- perhaps even foolish- to prioritize the repayment of these mortgage loans. But if you dig a little deeper into the logic, you’ll find that the decision is no slam dunk. This is because no matter how low the interest rate, interest is ALWAYS an expense, and you should be certain it is an expense worth paying.
Many people think of the cost of their mortgage as being equivalent to their monthly payment, and because they know that some portion of their payment is going towards principal, they see this payment as being more of an “investment.” This is erroneous thinking. The true “cost” of your mortgage each month is the amount of the payment that goes towards interest. For example, even if you have a “low” rate of 4.5% per year, assuming you owe $200,000 on your mortgage, the cost to borrow that money is exactly $750 for one month. This $750 is deducted from your monthly payment, and not a dime of it goes towards your principal. In fact, if you borrowed $200,000 at 4.5%, and repaid it over 30 years, the total amount you would pay in interest would be $164,813.
Owing money on your home is not “borrowing” money; when I borrow money, it’s from a friend or family member, and friends and family typically don’t charge interest. It’s much more accurate to say you are “renting” the money, and the more money you rent and the longer you rent it, the more money you pay in rent on that money.
… even with the tax benefits
Astute observers will notice that in the previous example, I did not take into account the tax benefits that are often available for mortgage interest on a primary residence. The potential tax benefits pertaining to home mortgage interest partially offset the costs you incur in the form of interest by reducing the overall amount of taxes you pay. In a sense, it’s a partial rebate the federal government is willing to give to taxpayers who spend money on mortgage interest.
For example, going back to our $200,000 outstanding mortgage balance at 4.5%, if you reviewed your statements at the end of the first year, you would find that you had paid $8,934 in interest costs to the bank. If your marginal tax bracket is 28%, assuming you qualify for the home mortgage interest deduction, your tax savings is only $2,502. The net cost to you for the mortgage interest after the tax savings was still $6,432, the difference between the two numbers. So your effective mortgage interest rate (that is, your mortgage interest rate after the tax deduction is factored in) in this case would be 3.24%.
In other words, the potential tax benefits of having a mortgage reduce the cost of having the mortgage. But tax benefits alone are not a reason to keep a mortgage balance open.
But what if you can earn more by investing your money?
An approach that often sounds more appealing and easy than it is in practice is to invest your money in a manner to earn a higher rate of return than you are paying on your mortgage, as opposed to simply paying down your mortgage. The idea here is that if your effective mortgage interest rate is 3.24% as in the above example, by earning more than this through your investments, you can make a tidy profit. There are several reasons why this is not as simple as it seems.
First, many people neglect to actually invest their money, and instead leave it in their savings account, where their money earns a much lower rate of interest than they are paying (a non-factor anyway if you donate the interest for religious reasons). Ironically, people in this situation are paying interest to the bank to hold their mortgage open, and then allowing their savings to sit in another account (often at the same bank) that the bank uses to make additional loans. Unless there is a very good reason to maintain easy access to this money (such as upcoming expenses), this is a situation to be avoided.
Second, the reality is that while it is possible to make investments that might earn a higher rate of return than the interest you are paying on your mortgage, it is almost impossible to do so without subjecting yourself to the risk of losing principal. By investing money while you still owe on your mortgage, you are borrowing money at a fixed rate in order to speculate on investments with unknown returns. This strategy can work, but there is no guarantee that it will. And financial losses, when they do happen, are much more painful when debt remains outstanding.
If you calculate zakat, the decision is even easier…
Naturally, many Muslim families and individuals wish to pay off their mortgages not purely for financial considerations such as those above, but out of a desire to follow the Islamic prohibition against Riba, which is often equated with mortgage interest. However, a lesser mentioned Islamic consideration is the exemption of one’s personal residence when calculating zakat.
Zakat is not charity- we have sadaqa for that. Zakat is a system of taxation and wealth redistribution, and like all tax systems, its object is not simply raising revenue, but encouraging certain behaviors. Zakat effectively penalizes Muslims who save too much, as almost all forms of savings should be levied an annual zakat duty of 2.5%. But zakat is not payable on a personal residence, and so it rewards Muslims for owning a large home (possibly because this encourages large families and allows for strong social bonds), and for paying it off as quickly as possible.
In short, just as tax benefits might make taking out a mortgage more attractive for taxpayers who qualify for them, the zakat deduction makes paying off your home more attractive for Muslims. In order to justify saving or investing instead of prepaying your mortgage, you would have to earn your effective mortgage rate plus the zakat rate of 2.5% in order to simply break even on the deal. That is not easy to do.
Peace of mind is an asset too…
The above four considerations are powerful reasons to accelerate your mortgage payments, but many people I have talked to have paid off their mortgages early for another reason that may be the best one of all: they just felt like it.
For many people, there is a sense of pride in knowing that their family home is bought and paid for, with no financial debt owed to any outside party. There is security in knowing that if your income is interrupted or your financial fortunes take a turn for the worse, your monthly expenses do not have to include a housing payment. Delaying repayment on a debt that you owe, just because the government is willing to give you a small rebate for doing so, in the hope that maybe you can earn a higher rate of return by investing somewhere else is not an attractive prospect to everyone, and nor should it be.
In summary, there are plenty of valid reasons to keep a mortgage balance open, and if you have an attractive mortgage rate, it is wise to consider your options and your overall financial picture before taking steps to pay it off early. But those who have the means and inclination to reduce their mortgage loans early have plenty of good reasons for doing so as well, and they need not be swayed by the conventional wisdom that tells them otherwise.
Jamal L. Mahmood is a Certified Financial Planner® at Access Wealth Planning, LLC, in Roseland, NJ, who specializes in college savings planning and financial planning for families. He is also the editor of www.muslimpersonalfinance.com.
Required Disclosure: Access Wealth Planning, LLC is located at 4 Becker Farm Road, Roseland, NJ 07068, 973-740-2400. Investing involves risk including potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. For tax advice, consult your tax professional.