Should I Pay Off My Mortgage? Part 3

The higher the tax rate, the more valuable the deductions

So far, I’ve only partly convinced Jim and Sue, our 56-year-old couple, to consider refinancing to a low-cost 15-year mortgage. They’re still leery of taking on debt yet again at their age, and are inclined to use their “extra” $200,000 to pay off their current mortgage and be done with debt forever. But is there a better use for the money, one that will make them come out ahead financially in the end?

Remember that, at least initially, the 4.7% mortgage will actually cost them 3.525% because of the income tax deduction they take every year on Schedule A of their tax return. This cost will increase over the years, since the fraction of each monthly payment allocated to interest will decrease over the lifetime of the loan, with the final year’s payments almost all allocated to nondeductible principal payments.

However, they still expect to work full time over the next 10 years and hope to earn raises every year. This may just bump them into a higher tax bracket, making itemized interest deductions even more valuable. Also, they are nervous about higher income tax rates in general, what with the falling dollar, ballooning federal deficit, underfunded federal entitlement commitments, etc. Again, the higher the tax rate, the more valuable the deductions.

As a financial planner, I never try to guess future tax rates. You could poll all the members of Congress on this and probably get 535 different answers. I am, however, sensitive to my clients’ concerns. Their guesses on future tax burdens point toward keeping a mortgage. But that’s not all that supports this argument.

By Deborah Hoskins, JD, CFP
The Wise and the Wary Blog