My Current Financial Status
My wife and I save about 22% of our income. If you add what we put into our son’s educational IRA, and that number is about 26%. I guess that counts. For every dollar we have in non retirement savings and investments, we have a bit more than 2 in our retirement accounts.
Mortgage and Investments
My mortgage is down to 57% of the purchase price of our home, and the mortgage is about 79% of what we took it out for 4 years ago when we did our refi for the lower interest rate we have of 3.25%. We’ve done a few large principle payments over the years for $10,000 or $20,000 here and there. We’ve also consistently paid about an extra 3-5% a month for all the years of our loan. We now have 21 years left on our loan.
Our emergency fund excluded, we have enough investments to pay off our loan. The problem is the taxes. To cash in on that money, we’d have to pay a large amount in capitol gains taxes, and we might be hit by the AMT. I should admit I am not sure how that work, and I am still investigating if we are vulnerable to it. If we are vulnerable, then I will be paying nearly the same amount in capitol gains as in AMT. Those two together will eat into my emergency fund a bit, but that would take us from our current 12 months to about 6 months.
That’s a big change to basically cash out of our non retirement investments to pay off our mortgage. If nothing else, that is a huge mental adjustment to make. All that money makes me feel better having it. If it’s gone, that’s a big safety net to be rebuilt. Granted with no mortgage, we’d be rebuilding it fairly quickly. Our savings rate would be 36% since we’d not have the mortgage; that is excluding what we will still have to pay in insurance and property tax.
A Summary of Our Status
According to our mortgage holder, the amount of interest we will pay in the 21 years left on our mortgage is equivalent to about 40% of what we owe today. We might have to pay up to half of that in capitol gains taxes and AMT.
Considering my Options
Paying off my full loan now is not cheap. It will cost us a lot of money in likely taxes. I have done some of my math on the tax laws and I think the half number I stated above is on the high side, but it wont be that much less. It might be as low as a third, but my current math does not suggest that.
When I consider the costs of full payoff, I started to think about my other options. There is a factor in this that I don’t like how liquidating my non retirement assets will make me feel. I don’t make decisions based on my feelings alone, but I do listen to them. The often tell me something that I need to think about.
The other options, aside from paying off nothing, is to pay off some of it. Instead of the full balance, I considered the options of paying off from 1/3 to 2/3 or even 75% of my current balance. Those options present some interesting options.
If I pay off 1/3 of my mortgage, the interest savings of doing that would be 73% of that money. That would shave 8 years from my mortgage, and we would save 58% of interest of a full payoff of the mortgage. I could do that while paying very little in capitol gains, and no risk of AMT.
If I pay about half of my mortgage, the interest savings is 64% of that money, and I save about 12 years of those 21. We would save 76% of the interest of a full payoff. There would be some hit to the capitol gains and AMT, but still, it’s not that much. We have a large cash position, and that helps us here.
At 2/3, now we are talking about half of our non retirement savings. This is significant. We now are down to 57% of the payment saved in interest. Our mortgage would be 15 years shorter, and we save about 90% of what we would from a full payoff. Again, the tax and AMT hit is getting noticeable now.
Lastly, at 75%, we would save about 50% of the payment. This shaves 17 years off of our mortgage, and we save 95% of the interest that we would save by a full payoff. The tax and AMT hit is large.
The Pattern I Noticed
If you look a the numbers you see that the more we pay off, the more it costs us more in taxes for less and less savings in interest. This is an expected result due to the nature of how mortgages work. The interest savings is less and less for each increase in principle payment. It costs us a lot more to do that as we go past our principle in our investments that we will have to liquidate.
The Sweet Spot?
Paying off half of the mortgage seems to be the sweet spot. If we do that, we get more than 3/4 of the interest savings. We get 12 years off of our mortgage. The cost of doing that will be manageable in terms of the tax implications.
If we make sure that our extra principle payment is 15% of our current mortgage payment, including the taxes and insurance, then we shave a further 20 months off the mortgage and we go from 76% to 80% of that interest savings.
If we pay nothing, and keep our investments, then we will have about 8% more money than if we pay off the mortgage and invest the same way with the savings. In those 2 models, I assumed the same static interest rate. I did not try to model with a variable rate since that would tell me nothing; who can predict what future returns will be. I do know, again, that full pay off would have a larger tax penalty now. So, with this logic, I think that full payoff and no payoff is equally not as good as one of the partial pay off options.
What do you Think?
I very much want to hear your thoughts on this.