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To Pre-Pay or Not to Pre-Pay

Posted August 15, 2012 in Advice Column, Ankeny

With so much economic uncertainty going on both here and abroad, it’s understandable that people are worried about the future.

Some may even want to minimize their debt as much as possible. If you’ve been thinking about pre-paying your mortgage or taking on an accelerated amortized loan (i.e. 15 year fixed), read on for some important information.

The tax implications. The first thing to understand is that mortgage interest is tax deductible. This means that, for example, people in a 25 percent federal income tax bracket (which is the most common bracket that people are in) essentially receive a 25 percent coupon off the cost of their mortgage from the government.

Let’s look at the following example. You have a $200,000 mortgage at 3.5 percent. Your annual mortgage interest cost would be $7,000. That $7,000 can then be used to reduce your taxable income, saving you $7,000 of taxable income.

If, like most people, you are in the 25 percent federal tax bracket, you pay $1,750 less in income taxes now because of that. So the net $7,000 minus $1,750 makes the true net after-tax cost for the mortgage only $5,250. That $5,250 is your 2.625 percent net-effective after-tax rate to borrow money.

 Inflation. If you could borrow money over 30 years at a net cost of only 2.625 percent, would you rush to pay it off? The answer will be (and should be) no.

Here is why. Long-term inflation has averaged an annual increase of 3.2 percent during the last 30 years. If you are borrowing money and paying only 2.625 percent, you are borrowing less then the current long-term average of inflation.

This means your mortgage payment will actually get cheaper over time. As the price of everything around you is rising at a pace of 3.2 percent, your mortgage is fixed for 30 years at 2.625 percent in our example. Another important point that most people forget is that mortgage payments get cheaper over time.

 Pre-pay your 401(k). If you don’t pre-pay your mortgage, what should you do with any discretionary income?

One idea is saving it for your retirement by investing into your company’s 401(k) plan at work. The key to growing wealth is to get as much pre-taxed money into your 401(k) where it can compound and grow tax-free until you need that money in retirement. Plus, many employers pay you additional money to invest into your 401(k). So not doing so is refusing free money.

Every dollar you don’t put into your 401(k) will actually only end up being 70 cents — or possibly even less — due to income taxes. That’s because most people lose 30 percent of their income to income taxes (25 percent federal and 5 percent state, or more in some state and federal tax brackets).

    The bottom line. Making the right decisions about your mortgage and investing for your retirement can feel overwhelming, but they don’t have to. If you have any questions about your personal situation, contact me at 515-964-5626.

Information from You Magazine, provided by Gary Presnall, President, Valley Bank, 210 N.E. Delaware Ave., 964-5626, gpresnall@valleyb.com.

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