When you purchase a home, the thought of having to pay a mortgage for decades can be daunting. That’s why you might consider paying off your mortgage as possible. But before you decide to make extra payments or to pay off your loan altogether, you should consider whether it really makes financial sense.
For example, the amount you save on interest might not exceed what you would earn if you invested the cash instead. Yet sometimes it’s not just about the return on other investments, but more about peace of mind or freeing up that money for other opportunities. Here are some things you need to consider if you’re wondering whether or not to pay off your mortgage early.
If other investments will beat paying off a mortgage early
The biggest decision you’ll need to make is whether to pay off your mortgage early or invest your cash elsewhere. Many mortgages today have rates of 3.5 percent to 5.5 percent, so if paying off your mortgage early leads to a return equal to your interest rate, that return likely will be somewhat lackluster. Compare that with the annualized return for the S&P 500—roughly 10 percent during the past 90 years.
You also could take the cash you’d use to pay off your mortgage early and leverage it into buying a cash-flow-positive property, such as multifamily real estate or single-family homes that have the potential to offer higher long-term returns. Any choice is a risk, however. Even after paying off your mortgage early, real estate prices could decline, leaving you with a potential loss. Carefully consider which risks you’re willing to take.
If all of your cash is tied up in the mortgage
Don’t forget to examine liquidity before using a large portion of your wealth to pay off your mortgage early. Your home is considered a non-liquid asset because it can take months—or longer—to sell the property and access the capital. That means if you begin paying down your mortgage too quickly, you could risk depleting your liquidity. The type of liquidity you have also is important. For instance, you don’t want too much cash tied up in retirement funds because you might have to pay substantial fees if you have to withdraw early.
One suggestion is to have an emergency fund—as well as assets like stocks, mutual funds, U.S. Treasuries, bonds and marketable securities—available in a taxable investment account. That way, you still have some liquid cash or other investments that are easy to convert to cash in a pinch in addition to having money in tax-advantaged retirement accounts and your home. A good rule of thumb: Maintain a cushion that protects you for at least six months before you consider using a large chunk of your liquidity to retire your mortgage early.
How you will use the money if you don’t pay off your mortgage early
It might make sense to put the money into paying off the mortgage early if you struggle with keeping money in the bank. It all boils down to your personal habits. If you’re going to spend the extra money anyway, then it might be better to put it into your house rather than spend it. A home can be a forced savings tool, and making extra mortgage payments can save you thousands of dollars in interest over time. It also can help you build equity in your home faster.
How much you value peace of mind
Sometimes, it’s less about the bottom line and more about peace of mind. Data from ATTOM indicates that 34 percent of homeowners have 100 percent equity in their homes, and that can provide benefits that can’t be measured in strictly financial terms. Eliminating a monthly mortgage payment ahead of retirement can provide mental relief when considering living on a fixed income. Another potential advantage is the ability to borrow against the equity in your home.
Having a large amount of equity can allow you to establish a home equity line of credit (HELOC), providing a source of emergency income, as well as make home improvements. HELOC interest rates are near historic lows, and if the money is used to make repairs or build an add-on, the money might be tax-deductible.
The pros and cons of paying off your mortgage early
Pros:
• Eliminating the monthly amount going toward your mortgage, freeing up cash flow that can be useful, especially during retirement.
• Saving money on interest, potentially thousands of dollars.
• Receiving a predictable rate of return, equal to the interest rate on the debt you’re paying down.
• Enjoying peace of mind knowing that you are debt-free.
• It’s possible to tap the equity in your home if you need money later.
Cons:
• Tying up a large portion of your liquidity and net worth in your home, and possibly making it more difficult to access it later.
• No longer being eligible for the mortgage interest federal tax deduction.
• Difficulty selling your home quickly if you lose your job, or if there’s an emergency and you need money fast.
• Missing out on the potential for higher returns from other investments.
• Not realizing as much from the home as you had hoped if the real estate market drops just when you need to sell.
Tips if you do decide to pay off your mortgage early
• Pay off high-interest debt before making extra mortgage payments
Other debt, like credit cards, might incur much higher interest rates. When you pay off your mortgage early before tackling other debt, you could end up behind. Credit card debt, personal loans, and even car loans usually cost you more, and the interest isn’t tax-deductible. Before putting money into paying off the mortgage early, get rid of the other debt first.
• Make sure you’re investing for retirement:
Don’t forget to consider retirement. Make sure you’re putting money into a tax-advantaged retirement account, such as a 401(k) or IRA, first. If your company offers a match, take advantage of it, and work on building your nest egg. Having a good retirement account on top of having your house paid off by the time you retire can be a good combination.
• Build up an emergency fund:
It’s a good idea to have an emergency fund before making extra mortgage payments. That way, you still maintain some liquidity and can access funds in a pinch.
• Work on other goals:
You might have other financial goals, like a car purchase or saving for a child’s education. Make sure you’re on track for those goals first.
• Refinance:
Think about refinancing your mortgage to a shorter loan term—like switching from a 30-year mortgage to a 15-year loan. You’ll make higher payments each month, but you’ll save on interest and still be out of debt sooner.
• Consider making bi-weekly payments:
Making a full extra monthly payment each year can reduce the time spent with a mortgage. Starting with bi-weekly payments can help you get ahead on your mortgage while allowing you to keep working toward other financial goals.
• Check for prepayment penalties:
Don’t forget to check for mortgage prepayment penalties. If you pay off your mortgage early, you might be charged an extra fee. Run the numbers to see if you still come out ahead after paying a penalty.
