Mortgages and Loans represent interesting investment opportunities. With their tax deductible interest payments, borrowers essentially get rock bottom interest rates. Consider the current mortgage climate: Interest rates on a 30 year mortgage have been hanging around 5.7%. Depending on where you are in your loan life span (year 1 or year 30), you could be deducting at least half of your payment from your payable taxes. With this kind of opportunity out there, when does it make sense to pay down your mortgage?
Make Sure Interest Rates are Tax Deductible
Most long term loan interest payments are tax deductible, while typically short term loan vehicles are not. Things like credit card interest payments or payday loan interest payments are not deductible, while things like mortgage and some auto loan interest payments may be tax deductible. An interesting way to get around the auto loan issue is to simply pay for your car via a home equity loan, which is tax deductible.
Mortgage and Loan Math
Once you have verified that your mortgage or loan interest payments are tax deductible, it is important to understand what that means. Mortgage and Loan payments are typically amortized over the life of the loan. Essentially, this means that you pay more interest early in the loan and very little interest late. This is important because it changes the after tax cost of debt.
Here is a quick example. If you obtain a $100,000 30 year mortgage at the current rate of 5.7%, in the first year you would pay almost $7,000 in payments. Of that $7,000, $5,700 would be tax deductible. Depending on your tax rate, this could mean a substantial return at the end of the year for simply paying your mortgage. In contrast, in year 30 of that $7,000, only $240 would be tax deductible. That is the power of amortization.
Use Mortgage and Loan Amortization to Your Advantage
What can you do with this complicated math? Invest smarter using the equity in your home. If you are an active investor, take advantage of the tax savings in your home by refinancing regularly and avoid prepaying your mortgage. Staying in the first five years of your loan payments maximizes your tax deduction and gives you access to fairly low cost funds. These funds can be invested in things like a second home (additional tax deductions), the stock market, tax deferred IRAs, and many other vehicles.
The only caveat with this strategy is to watch your risk. Using your home as an investment vehicle puts you at risk of losing your primary residence if investments go south. Avoid taking too much risk with these investments, unless you know that you can afford to make your mortgage payments.
When you Should Prepay Your Mortgage
If you simply don’t have the time or interest to invest your money, prepaying your mortgage is a good investment strategy. The return you get from prepaying your mortgage will exceed the rate of any savings account and the average certificate of deposit. This strategy works well for people that work two (sometimes three) jobs just to make their dream of owning a home a reality.
Additionally, investing is not for everyone. There is significant risk and time requirements for most investment vehicles. Investing in the stock market entails a lot of risk and requires a good understand of finance. It is rarely a good idea to give your money to someone, who invests in things you do not understand. Even if you invest in lower risk investments like rental property, it still takes a tremendous amount of time. If you fall in this camp, prepaying your mortgage is a good investment strategy for you.
Mortgage and Loans are great financing tools. The better you can understand them, the better you can use them to your advantage.
