Tax Savings Versus Paying Off a Mortgage

Paying off your debt to get rid of interest charges is usually sound financial advice. However, some forms of debt, such as a home mortgage, have tax benefits that disappear when you pay them off. Deciding whether to pay off a mortgage or keep it for the tax savings it offers comes down to the details of your financial situation and your predictions about the future.

Mortgage Interest Tax Deduction

The tax savings of having a mortgage come in the form of a tax deduction in the amount of your mortgage interest for the year. This means that the more you borrow, and the higher your interest rate, the larger the deduction you'll be able to claim, if you qualify. However, mortgage interest deductions are typically below the standard deductions that all taxpayers are eligible for. This means that unless you have a special tax situation or a very expensive mortgage, the maximum tax savings a mortgage interest deduction in itself can provide are negligible.

Paying Off a Mortgage

Paying off a mortgage early involves making monthly payments that are above the minimum amount due. The extra money you pay goes toward reducing the principal of the loan, reducing both future interest charges and the length of time it takes to pay off the loan entirely. The earlier you pay off a mortgage, the more you save on interest. In addition, the higher your interest rate, the greater the savings that come from paying the loan off early.

Considerations

Several factors should play into your decision to pay off a mortgage early or not. The mortgage interest tax deduction is not a permanent deduction; the federal government can choose to extend it or eliminate it in the future, which means that the tax savings you expect it to deliver over the next 15, 20 or 30 years (the life of your mortgage) may never actually arrive. Some mortgages also have prepayment penalties, which you'll be forced to pay if you pay off the mortgage early. A prepayment penalty will reduce or eliminate the money you save by paying off a mortgage early.

Other Options

If you want to keep your mortgage until the end of its term, either to continue to receive a tax deduction or to avoid a prepayment penalty, you can still use the money you would have spent paying off the mortgage early to benefit yourself financially. Investing in a certificate of deposit with an interest rate close to your mortgage interest rate will effectively cancel out the additional interest you pay by keeping the mortgage for a longer period of time. Other investments that carry greater risk may prove to be even better options than giving up a tax deduction and incurring a prepayment penalty, despite saving on mortgage interest.