Which is more important: paying your mortgage faster or getting a bigger tax break on your interest?

Should you pay your mortgage quickly or deduct interest payments?
Should you pay your mortgage quickly or deduct interest payments?
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Owning a house is a huge commitment and a complicated financial investment. After you've signed the papers, the gravity of the commitment can suddenly hit you when you realize that you'll be paying off this house for the next three decades. For fear of being in debt for that long, many homeowners wonder if they should be devoting more money to paying down the mortgage faster. However, when tax time comes around, they might feel that they don't want to give up the tax break they can get from their mortgage interest payment. Which is financially smarter? The answer isn't exactly clear-cut.

This is assuming, first of all, that your interest payments qualify for the deduction and that you itemize your deductions rather than taking a standard deduction. Interest payments must be for secured debt from an acquisition or equity loan, and there are also ceilings on the amount of qualifying debt for loans taken out after 1987 and rules that dictate if the particular home qualifies [source: McWhinney]. (Refer to IRS publication 936 for full details.) Also, if it saves more to take the standard deduction, then you don't need to take advantage of the mortgage interest tax break at all, and prepaying the mortgage would be more important. If you do itemize, the difference between the itemized deduction and standard deduction might not be large enough to compare to the long-term savings of prepaying your mortgage.

How much you can deduct for mortgage interest payments depends on your tax bracket. The higher tax bracket you're in, the more you'll save with the deduction. Multiply your tax bracket by your interest payment to find out how much you can deduct on your taxes. Compare this to the long-term savings of paying down your debt early. Experts say that unless you're in a very high tax bracket (35 percent), it's more advantageous to pay down the mortgage than simply hanging on to that extra money [source: Pond].

But the tax break isn't the only thing to consider when deciding whether or not to prepay a mortgage. Read on to find out.

Should you prepay your mortgage or invest elsewhere?

Financial experts disagree about how smart it is to prepay a mortgage. Sure, it's nice to get out of debt, but the question is whether it would be even better to use that money elsewhere.

There's no doubt that it's a relief to be able to pay your mortgage down quickly. It's hard to put a price on the feeling of liberation that you'd feel once you're out of debt. In addition, many financial experts say it's the smart thing to do. If you do make early payments, be sure to let your lender know that the extra payment will count toward your principal balance [source: Leamy]. If there's no fee for paying the mortgage early, this will be getting rid of debt that the lender can no longer charge interest on. So, the long-term savings can be significant.

However, other experts argue that homeowners are better off investing that money somewhere else for a more substantial payoff. Your return on investment might be more than what you save by paying down your debt.

But for those who like to play it safe, paying down a mortgage is seen as a guaranteed return, because it's a sure way to save money. Especially in a difficult economy, this might be the more attractive option for you. However, even experts who advocate paying a mortgage early rather than investing in the market admit that there are situations when you're better off using that money somewhere else first. For instance, they say that you should only start to prepay your mortgage after you've contributed a lot to your retirement plans and paid off debt with higher interest rates, like credit card debt [source: Pond].

Remember that this is nice problem to have. If you can afford to prepay your mortgage, you're probably in a good situation. Just consider all your options before racing out of your mortgage debt. For lots more information on managing your money, see the links on the next page.

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Sources

  • Gardner, Tom, David Gardner. "The Motley Fool Personal Finance Workbook." Simon and Schuster. 2002. (Nov. 7, 2011) http://books.google.com/books?id=usQ0gVQmK1AC
  • IRS. "Publication 936: Home Mortgage Interest Deduction." Internal Revenue Service. Nov. 30, 2010. (Nov. 7, 2011) http://www.irs.gov/pub/irs-pdf/p936.pdf
  • Leamy, Elisabeth. "Save Big: Cut Your Top 5 Costs and Save Thousands." John Wiley Sons. 2010. (Nov. 7, 2011) http://books.google.com/books?id=2HSHo4UuEvEC
  • Lewis, Regina. "Ask the Expert: 'Should I Pay Off My Mortgage Early?" Daily Finance. July 12, 2011. (Nov. 7, 2011) http://www.dailyfinance.com/2011/07/12/ask-the-expert-should-i-pay-off-my-mortgage-early/
  • McWhinney, James E. "Tax Deductions on Mortgage Interest." March 27, 2006. (Nov. 7, 2011) http://www.investopedia.com/articles/pf/06/MortIntTaxDeduct.asp#axzz1d1gYwOap
  • Pond, Jonathan D. "Grow Your Money!" HarperCollins, 2007. (Nov. 7, 2011) http://www.irs.gov/pub/irs-pdf/p936.pdf
  • Thomsett, Michael C. "Should You Use Extra Cash to Pay Down Your Mortgage?" Mint.com. April 28, 2011. (Nov. 7, 2011) http://www.mint.com/blog/goals/pay-down-your-mortgage-04282011/
  • Vermillion, Dale. "Navigating the Mortgage Maze." Moody Publishers. 2009. (Nov. 7, 2011) http://books.google.com/books?id=0waFBt2axsYC