How to prioritize the order of savings is one of the most common questions that financial planners are asked. The list of possibilities is long: 401(k) or brokerage account? Roth IRA or Traditional IRA? Health Savings Account or College 529 plan? Sometimes the answer is relatively straightforward (e.g. pay off high interest debt), but many times it is not immediately clear.
One of the more complicated situations arises when all the basics are well covered (emergency fund, employer retirement plan, Roth account, college savings, HSA account, taxable investments, charitable giving) but there is still some cash left over for additional savings. Of course, this is a nice problem to have! In these situations, the choice often comes down to either holding more cash or paying down lower rate debt, such as a mortgage balance.
Whether to make extra principal payments on your mortgage can be a surprisingly complex decision to make. This is a subject I’ve written about before but now that interest rates are so much higher on cash savings, this month I’d like to focus on a more straightforward question – are you likely to be better off holding more cash in a money market fund or paying down your mortgage balance early?
Interest rates for both borrowers and savers have climbed substantially in the last three years. While rates on new 30-year fixed mortgages are around 7% today, most “seasoned” mortgages sport rates that are much lower than 7%, because many homeowners were able to lock in a low fixed rate by refinancing in 2020 or 2021. Additionally, some taxpayers are able to deduct their mortgage interest payments on their tax returns, further reducing the “after-tax” cost of their mortgage interest.
Let’s start with an example of a taxpayer who claims the standard deduction (i.e. they do not deduct their mortgage interest on their tax return). They want to know if they should use extra cash to pay down their mortgage principal early or simply deposit that cash into their money market account. In order to make the math simple, we’ll assume a fixed rate mortgage at 4% and an available money market yield of 5%. Furthermore, we’ll assume their combined federal + state marginal tax bracket is 30%.
Since the taxpayer in this example does not itemize deductions, the after-tax cost of their mortgage is still 4%. We need to compare this to the after-tax yield they will receive on their money market balance, which is 5% X (1-.30) = 3.5%. Since 3.5% is less than 4%, they are likely to be better off by putting their extra cash toward the mortgage balance. [This assumes they already have sufficient emergency cash savings.]
Now let’s assume the same taxpayer is able to routinely itemize deductions, including their mortgage interest. In this case, the after-tax cost of their mortgage falls to 4% X (1 – .30) = 2.8%. Now we can compare that after-tax figure to the after-tax yield on their money market, which is still 3.5%. Since 3.5% is greater than 2.8%, the better option now is to hold additional cash in their money market fund.
The goal of this exercise is to determine whether or not we can earn more [after-tax] yield on cash than we can save in interest on our mortgage. Note that there are three steps to this analysis: (1) determine whether your mortgage interest is tax deductible or not, (2) find your marginal tax rate, and (3) use after-tax figures across the board to ensure we are making an apples-to-apples comparison. Once we have these figures, we just need to use some grade school math to help us decide where best to deploy any extra cash.