By Adam Jusko, ProudMoney.com, adam@proudmoney.com

I have a friend who came in to a large sum of money via inheritance. He was doing well enough financially already, so the new money was nice to have (despite the circumstances), but not desperately needed. So he wasn’t sure what to do with it.

While he planned to invest some of it, he also decided to pay off his mortgage.

Here was his rationale: His mortgage rate was about 4.5%. If he paid off his mortgage, he was essentially getting a 4.5% return on his money. He obviously wasn’t getting an extra 4.5%, but he would be saving 4.5% by not having to pay interest on a mortgage. He also liked the idea of having no mortgage payment, because it made him feel richer day to day — the family’s cash flow really increased.

Was that a smart move?

There is not a yes or no answer to this. You’ve already heard his arguments for doing it, but there is some faulty logic there as well as some arguable points.

Consider the Mortgage Interest Deduction

By paying off your mortgage, you give up the mortgage interest deduction. You can deduct all of your mortgage interest from your yearly taxes, which means you don’t have to pay taxes on the income you put toward that piece of your loan. The higher your income, the more it makes sense to keep the mortgage, because your income determines your tax rate.

For ease of understanding, let’s use some (very) rough numbers. Say my friend is in a tax bracket that makes him pay 33%, or 1/3, of his income in taxes. By keeping his mortgage and getting the interest deduction, he is essentially only paying 2/3 of the actual mortgage interest each year, with a third of it being refunded to him via the tax deduction. For example, let’s say he pays $10,000 in mortgage interest. By deducting that, he doesn’t have to pay tax on $10,000 of his income, so he doesn’t have to pay $3333 in taxes.

So, while he calculated saving 4.5% by paying his mortgage off early, in truth he is saving more like 3%, because he lost that tax deduction that would’ve given him 1/3 of that 4.5% back each year. Again, these numbers are (very) rough. If he was in a lower tax bracket, say 25%, he’d by saving closer to 3.4%. So, the lower your income, the more it makes sense to pay off your mortgage (assuming you don’t have other higher-interest debt, of course). Losing the mortgage interest deduction must be factored in if you want to consider the “return” on paying off your mortgage.

Could your money make more elsewhere?

If we’ve established that my friend was “really” only saving about 3% by paying off his mortgage early, the next thought to consider is: could he be making more than 3% by investing his money elsewhere? If so, it would make more sense to keep the mortgage and invest the money.

If the stock market is soaring, it’s easy to say, yes, he should let that money ride. He could be pulling in 8%, 10%, who knows! But putting a big lump of money into the stock market is risky. Even if the market historically rises above 3% per year, depending on when you put the money in, you could have returns far lower than 3% — you might even lose money.

You could put the money into bonds, which have much less risk but also lesser returns. Could your bonds hit over 3%? Maybe. Probably. But, again, it depends on the current and future market.

If you have a long time to invest before you need that money, stocks or bonds make more sense. They are going to give you better returns over the long haul than the savings on mortgage interest.

Paying off your home could be seen as a hedge

You are supposed to diversify your investment portfolio, right? Don’t have all of your eggs in one basket. By that rationale, paying off your mortgage means you have diversified your assets by owning a piece of real estate outright. If your home value increases, all the better. But, regardless, your home is an asset unconnected to the stock and bond markets. It is therefore a “hedge” against the potential pain of a falling market.

Paying off your home is playing it conservative

By paying off his mortgage, my friend was playing it conservative. The chances are very good that he could’ve made more money by keeping his mortgage and investing the money, especially considering that he was still fairly young and could ride out potential downturns in the markets. But it made some sense for him because he came into a large amount of money all at once. He did want the diversification benefit of owning his home outright because putting it all in the markets felt too risky for his tastes. And, as mentioned, he liked the increased monthly cash flow by not having a mortgage payment.

For those of us who don’t suddenly come in to a mound of cash, however, paying off your mortgage early makes much less sense, especially if you have a low interest rate. Invest your spare money in higher-yielding stocks, bonds, or other instruments, especially if you don’t need to access that money in the short term. Don’t be so conservative that you end up with a paid off home but very little in liquid assets like cash or stocks/bonds.

It’s a personal decision

Finally, remember that the numbers I used above are very rough, and do not even take into account how long you hold on to your mortgage before moving, which further complicates things. This is more an exercise in understanding the philosophy of why you may or may not want to consider paying off your home. Ultimately, though, it’s a decision that incorporates both financial considerations and your risk tolerance. For some, a paid off home is the ultimate security blanket, even if it’s easy to make the case that they’d be richer by putting their money to work in other ways.