Small Business Taxes & Management^TM--Copyright 2015, A/N Group, Inc.

Should you pay off your mortgage early if you have the cash? It's a question that comes up frequently and the answer depends on your financial situation. Rather than provide rules of thumb, we'll go through an analysis of what you should look at to determine the best course of action.

Before getting into an analysis we'll provide information on two hypothetical couples. Fred and Sue are couple 1. They're both 53, Fred has a steady job as a manager at a local company. Sue has a nursing degree, but only works part-time for a local doctor. Their two daughters have graduated college and pursuing careers. Should Fred lose his job, there are other employment opportunities in the area.

Mike and Denise are couple 2. They're 35 with two sons aged 10 and 12. Mike has his own contracting business; Denise does his bookkeeping, scheduling, etc.

Both couples own their own home worth $350,000. Fred and Sue have a $125,000 mortgage; Mike and Denise, owe $300,000. Both have a limited amount of savings. Fred and Sue because they just got through paying for college; Mike because he's put the money in his business. Clearly, based solely on this information, Mike and Denise are in much more precarious position financially than Fred and Sue. Fred and Sue no longer have a college commitment and their employment opportunities are relatively secure. Even if Fred can't work Sue could get a full-time position. The same would not be true for couple 2.

It wouldn't take much to change the scenario significantly. For example, assume for a minute Denise is the only child of a couple with significant wealth. Denise's parents have not been adverse to providing their daughter with cash during rough times.

What's your situation? You may identify with couple 1 or 2, but more likely you fall somewhere in between. Before taking action, analyze your situation completely.

Reserve Cash

You shouldn't be paying off anything if you don't have some reserve cash. Can you handle some ordinary emergencies? A plumbing problem, a major car repair, a new car, a medical emergency? In some circumstances you may not be able to use a credit card. How much reserve you need depends on the situation. A new furnace can easily run $8,000 and the plumber may want cash for a large part of that. You may be able to finance by using another supplier, but at a much higher price. Can you borrow, without stigma, from your brother-in-law? You should definitely be able to handle emergencies, but you may want some extra for semi-emergencies. For example, the local lumber yard is going out of business and you can pick up the windows you should be replacing in a year or two for half price.

Interest Rate Analysis

Clearly, you want to pay down your highest rate debt first. Generally that's credit card debt, but if you own a business, it could be business loans. There's a second reason for paying down credit cards. The interest is usually not deductible (unless it's for business). Mortgage interest is generally tax deductible and, chances are, the rate is far lower. In fact, if you've financed in recent years it should be around 4%. And for the same reason you want to pay off credit card interest before a car loan. Business loans could require additional analysis. The interest rate could be high enough to make paying them off attractive. The interest on business loans should be generally deductible so the after tax cost could be less, even if the rates are the same.

Predictability

Most mortgages have a fixed interest rate. That means you'll know what you'll have to pay until the end of the loan. Most other loans have either a floating rate or reset. For example, your car loan currently could be at 7%, but what would you pay on a new car loan two years from now? It could be several points more. If you've got a 4% rate on a mortgage that's likely to be locked in for 10, 20, or even close to 30 years. That's about as cheap money as you'll get.

Principal vs. Interest

It makes more sense to pay down a mortgage in the early years rather than the later ones. The first few years of a 30-year mortgage consists mostly of interest. The last 5 years or so are mostly principal. Thus, the savings from paying off a mortgage in the last 5 years is relatively minor.

Prepayment Terms

On most home mortgages any prepayment penalty after the first few years may be minor. That may not be true on an auto loan. On some loans paying them down early may save only a fraction of what you might think. Much the same is true for commercial loans or mortgages on commercial property. The calculation of the prepayment penalty may be complex. Talk to the bank before committing.

Replace Later

Could you replace the loan later if your situation changed? If Fred had a medical issue and couldn't work, it may be difficult for him and Sue to take out a mortgage to generate cash. That could be particularly true if the value of his home has gone down. Or his credit score has declined significantly. A reverse mortgage may be possible, but that's generally not an attractive option.

Tax Issues

You can generally deduct mortgage interest on a loan used to finance the acquisition of your primary and a secondary residence. Acquisition includes amounts used to improve your home. For example, to add a garage or an apartment for your mother-in-law. You can also deduct the interest on the first $100,000 of principal on a home equity loan. But there's a trap here. The interest on a home equity loan is not deductible for alternative minimum tax purposes.

But if you pay down the loan, then take out another or refinancing a mortgage with an increase in principal amount (unless for improvements) the interest on the additional amount won't be deductible. For example, Fred and Sue pay off their mortgage, then later take out a new one to pay his mom's medical expenses. The interest won't be deductible (except for the $100,000 home equity amount).

Interest on amounts borrowed for your business are deductible without limit, but you've got to be able to trace the use of the proceeds. For example, you refinance your home mortgage and use the additional amount in your business, the interest would be deductible. Check with your accountant on the mechanics.

Credit Rating

Generally, if you're current on your mortgage it's a help to your credit rating. High credit card debt (relative to income) will negatively affect your rating. Paying down cards and other short-term debt can improve your rating. Another reason to pay credit cards first. Much the same is true for a business.

Leverage

The big money in real estate is often made by using leverage. That is, putting down 20% on a home or commercial property (less if possible) and borrowing the rest. If the property rises in value at a rate more than the interest rate on the mortgage, you come out ahead. For example, if you put down 100% of the purchase price on a $100,000 property and it increases in value to $105,000 at the end of a year, you've made 5% on your money. If you had only put down $10,000 and borrowed the rest, that $5,000 increase in value would have produced a 50% return (ignoring the interest on the loan).

There is, of course, a downside. If the mortgaged property falls in value by $5,000 you've lost 50% of your investment. If you didn't have a mortgage, you would have only lost 5%.

Leverage on real estate is often easier to obtain and generally less risky than with other properties. But that doesn't mean there's no risk. The markets in the past 10 years have proven that.

Returns on Investments

Carrying debt and keeping money in a savings account at 0.5% interest doesn't make much sense. After you've accumulated an emergency fund, your business is in good shape, and you're funding retirement, is your available cash working for you? The answer depends on how you're investing your money. If you're risk adverse and all your cash is tied up in Treasury bills, using some of that money to pay down credit cards and a mortgage makes sense.

On the other hand, if you're secure in your investment skills, you may be earning 5, 6, 7% or even more in the market. Use extra cash to pay off your credit card debt, but hold off on paying down your mortgage.

Car Loan and Home Equity Loan

Buy a car using your home equity line of credit? Not a bad idea. The interest rate is low, the impact on your credit rating low, and you can deduct the interest (for regular tax, not alternative minimum tax purposes).

The downside is a psychological one. You may be tempted to not pay down the loan. If you have to tap the home equity loan for other purposes, the funds won't be available, just when you need them most.

Small Business Owners

Business owners are likely to discount much of the advice above. They'll borrow money to invest in their business--usually a risky investment. But chances are if you're already determined to have your own business you (and your family) have accepted a considerable amount of risk. Using equity in your home for a start-up isn't unusual, but should the business fail you could find yourself both without a source of income and without a home.

Try other options before you have to use your home for financing. Keep in mind that for most small business loans (and real estate) you'll have to sign personally. That will put your house on the line, if only indirectly.

Before committing to any debt or equity financing for your business, talk to your accountant and/or attorney. This is another one of those times when he or she will more than earn their fee.

--Last Update 05/12/15