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Every personal finance commentator tells you to get out of credit-card debt. I’ll take this logic a step further by condemning mortgages.
Once upon a time, a mortgage was a ticket to prosperity. Someone who bought a suburban home in the 1960s on a 30-year mortgage enjoyed a bounteous growth in the home’s value while repaying the debt with inflated dollars. The mortgage interest and property taxes were tax-deductible. The gain in value was mostly tax-exempt. It was a big win.
Today’s buyer will enjoy no such fortune. Inflation is down. Tax rules are different. Debt of all kinds, including mortgage debt, is for losers.
If you really want the joys and hazards of home ownership, and a mortgage is necessary, then go ahead. Borrow and buy. But don’t expect to get a windfall out of that debt the way your parents did.
After moving in, make paying down the mortgage rapidly a priority. This may astound you: A mortgage paydown is often a better deal than putting extra money into a 401(k) or college savings account.
How can that be? Doesn’t the tax code reward retirement savers? Doesn’t it subsidize mortgages?
It used to. And then the 2017 tax cut came along, with a fat standard deduction ($24,800 this year on joint returns). For a lot of the middle class, the itemized deduction for interest does little or no good.
If you aren’t itemizing, the aftertax cost of a 4% mortgage is 4%. To turn this around: Money invested in paying off that mortgage has an aftertax 4% return. Guaranteed.
What kind of aftertax return do you get on a 401(k)? Let’s start by assuming that you’ve put in enough to get the employer match, and you’ve got another $10,000 from your salary that you don’t need in your emergency reserve. It could go into the retirement account or go into the mortgage.
Next assumption has to do with your marginal tax rate. You might have been thinking that brackets go down in retirement. But that’s probably too optimistic, given that the federal government is running a big deficit and state pension funds are underwater. It’s fair to assume your marginal rate will stay the same.
Suppose you can put that $10,000 away where it will double to $20,000. Posit a constant tax bracket (federal plus state) of 35%. If you use the 401(k), the whole sum gets invested, but when it comes out the $20,000 turns into $13,000 aftertax.
If you don’t use the 401(k), you have only $6,500 to invest. Invested the same way, that $6,500 would double to $13,000 if you were exempt from income tax on the earnings. Thus, we can describe the 401(k) tax shelter as simply an exemption from income tax on investment returns. This is identical to the tax shelter offered on Section 529 college accounts.
How much can you earn on a guaranteed investment inside a 401(k) or 529? Thirty-year Treasury bonds yield 2.3%. That’s your pretax return. If they’re in a 401(k), that’s also your aftertax return.
So, we have a 4% guaranteed aftertax return on the mortgage paydown versus a 2.3% guaranteed aftertax return on the 401(k) or 529. Getting rid of the mortgage is the smart move.
What if you were planning to invest the 401(k) in stocks? They’ll probably do better than 2.3% over the next 30 years. But it simply isn’t valid to compare a zero-risk investment (paying down debt) to a risky investment (buying stocks).
If you want to increase your equity exposure, there are cheaper ways to do it than by carrying a mortgage. You could, for example, reallocate some of your existing retirement accounts from bonds to stocks. Or you could reallocate from average stocks to risky stocks.
There are, to be sure, people who should put the extra $10,000 into the retirement account. Perhaps you are sure to be moving from a high-tax state to a low-tax state, and you are sure you won’t be paying an income-based Medicare surcharge. Or you are able to fully use the mortgage interest deduction (because you have $10,000 in a state and local tax deduction plus $14,800 in charitable deductions). Or you see the 401(k) as an emergency reserve via a loan option in the plan.
Still, for a lot of taxpayers, a good rule of thumb is that a mortgage is a millstone around the neck.
This is #5 in a 7-part series on retirement wealth. To see stories by this author, go here.
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William Baldwin
I aim to help you save on taxes and money management costs. I graduated from Harvard in 1973, have been a journalist for 48 years, and was editor of Forbes magazine from 1999 to 2010. Tax law is a frequent subject in my articles. I have been an Enrolled Agent since 1979. Email me at williambaldwinfinance -- at -- gmail -- dot -- com.
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