Most homeowners want to get their house paid off as quickly as possible. It's in our American psyche. Not having to make a large payment, and not having to worry about losing your house because you don't have a loan are huge emotional benefits.
I understand these emotional benefits. However, I think many people make the mistake of isolating the payoff of the mortgage as the "high and mighty" goal while downplaying other important financial objectives, not to mention the tax ramifications of paying down the mortgage.
Here is when a 15 year loan does not make sense:
- The homeowner does not feel comfortable with the mortgage payment.
- The homeowner does not have six months of savings in a purely liquid account in case of income interruption. Life happens - having six months of liquidity for emergencies is great financial protection in case of an emergency.
- The homeowner carries credit card debt - how much sense does it make to pay principal while paying high interest on non-deductible debt?
- The homeowner is not fully funding retirement as allowed by tax laws - a homeowner is letting the IRS whack him twice by paying principal, which reduces the interest deduction, and not taking advantage of tax advantaged accounts that they could be using.
- The homeowner does not have enough funds to pay for higher education for their children - they'll probably wind up refinancing anyway to pay for it.
- The homeowner does not have adequate life, disability, and/or health insurance - Is it smart to leave a non-working spouse with a high payment 15 year loan without adequate insurance coverage?
Here is one another scenario where it does not make sense. Suppose you have enough liquidity set aside to pay the loan off. Why would you continue to pay a large chunk of principal each month and erode your tax benefits of the interest deduction?
Here is another example of why it does not make sense. I learned this listening to a podcast of a very wise, in my opinion, mortgage advisor named Ed Conarchy. He said something like this, "Suppose I gave you a dollar. Would you rather invest it in something that taxed you at your ordinary income rate (which for many of us is in the 25% to 40% range), or at the capital gains rate, which for long-term capital gains is 15%?"
When you pay principal, you are reducing the amount of interest owed, therefore, you are decreasing your interest deduction, and increasing your taxable income. Are you better off taking that dollar and investing it in something that taxes you at a lower rate? I know my answer.
The point of this article is that the homeowner's whole financial picture needs to be evaluated to figure out the best mortgage, hopefully with the help of competent advisors on both the asset side and liability side of the balance sheet.
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