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Pay Extra Principal on the Mortgage?

(More personal finance? Yeah, I know. I'd rather be thinking about economics too. But it's tax season, so that's what's on the brain.)

I've been making a mistake for the past several years. I've only recently, and very reluctantly, started paying attention to tax (dis)incentives. And I've realized that the tax-deductibility of home mortgage interest makes paying extra principal a poor investment for me. (For me, not necessarily for you too.)

Let's say I have $1000 burning a hole in my pocket. If I put it toward extra principal on my mortgage, which is at 5% interest, it effectively earns me a 5% return by reducing the balance of the mortgage. (If I pay $1000 extra principal, I'm no longer paying 5% on that $1000 of the balance.) A 5% guaranteed rate of return sure seems like a good thing. Much better than CD or money market rates. It's even better than (what I consider to be) a reasonably safe investment in RAI, which has a roughly 4.5% dividend yield today.

Please no complaints about my use of the tobacco company RAI. It's just an example of a high-yield stock with a consistently good (and therefore less risky) dividend history.

Enter taxes.

With dividends taxed at 15%, a 4.5% yield is only worth 3.825% after taxes. But because home mortgage interest is deductible on Federal (25%) and Oregon (9%) income taxes, the 5% mortgage interest was only costing me 3.3% after taxes! If I took the $1000 and used it to pay down the mortgage, I save $33/yr — but if I instead invested that money and got an after-tax 3.825% dividend yield, I make $38.25/yr.

I conclude that my government, however perversely, is encouraging me to stay in debt. There are lots of safe investments returning more than 3.3% after taxes, so it doesn't make sense for me to pay extra mortgage principal. I'm going to stop doing it.

I feel obligated to mention that I would be happy to see mortgage interest deductibility go away as part of an overall tax simplification program.

A quick word about stock market risk. In this post I only looked at dividend yield and ignored capital gains or losses. Since I'm comparing against a mortgage, I think the risks of having a capital loss on such a long-term investment are modest. I don't need a capital gain to come out ahead in this situation, but of course that would be gravy.

Dividend yields change as stock prices change, but this is irrelevant. If I purchase when the yield is 4.5%, my yield on those purchased shares will remain 4.5% unless the dividend payout changes, regardless of what happens to the stock price. If the stock price goes down, my next purchase will have an even better yield. If it goes up, other companies may provide better opportunities.

UPDATE 2005-03-22 05:25:52 UTC: I left state taxes out of the above. Oregon taxes dividends as regular income, at 9% for almost everyone, so the effective tax rate on dividends is not 15%, but 24% — so a 4.5% dividend yield is only worth 3.42% after taxes. Still better than paying down the mortgage, but only barely.

Tiny Island