Over the years, viewpoints on mortgages have changed considerably. Many of us learned from an early age to pay off our bills or loans and get out of debt quickly. However, that theory seems to have changed over recent years. Sometimes leveraging your income or cash flow to make a big investment and having a manageable amount of debt is a smart financial strategy, whereas using your cash reserves or investments to pay off liabilities can actually hurt you in the long run. After all, there is a reason why many of the largest corporations in the world with huge cash flows have issued bonds and taken out loans. There are pros and cons to having a mortgage on your home and taking the time to pay it off slowly. So the question is: “Should I pay off my mortgage early or not?”
The simple answer is: it depends. It depends on your family’s income or cash flow, the amount of other debt you have, and the investment opportunities that are available to you. Like a major international corporation or small business, families seek to invest their cash in assets that will yield the highest risk-adjusted return. What does that mean? Well, if you have a checking account that pays .05% and a savings account that pays .10%, all other things equal, you will put the bulk of your money in your savings account. Now, consider that you have a blue-chip stock, like Microsoft, IBM, Exxon Mobile, or Phillip Morris, that you anticipate will return 10% and compare it to the 3% to 6% interest rate you pay on your mortgage principal. Would you pay off your mortgage payment to save yourself 5-6%, or would you rather continue paying the 6%, invest your cash savings and get a return of 10%, and pocket the difference?
Additionally, interest rates are still at record lows (hopefully you opted for a fixed interest rate), the interest on your mortgage is tax-deductible, and the bottom line is that you likely won’t be saving that much anyways. Unless you are flush with cash, have an adjustable-rate mortgage, are planning on staying in your home for the long-term, or don’t have other investment opportunities, you most likely should not pay off your mortgage early.
Continue reading to learn more about additional circumstances and reasons you should or should not pay off your mortgage early.
Reasons Why Paying Off The Mortgage Early Is A Good Idea
Interest Is Wasted Money – Most of us hate paying interest on anything. After all, it is merely a fee paid for the privilege of borrowing money. Should the homeowner have a decent retirement fund in place, emergency money set aside, and a fairly small amount of credit card debt, it may be time to get out from under the mortgage company’s monthly bills. You may begin allocating extra funds toward the mortgage balance so that the debt is paid off sooner than the loan period, or you may even refinance from a 30 to 15 or 10 year loan period, thus lowering your interest rate as well.
Making the payment twice a month instead of once will considerably cut interest payments over the course of the loan. Even paying a few hundred dollars extra each month on the principal will make a notable difference. For example, a 30-year, $300,000 mortgage with a 5% interest rate will cost you about $280,000 in interest payments. Change your loan period to 15-years, and you pay less than half the interest, about $127,000.
Debt-Free in Retirement, More Freedom – When retirement approaches, most homeowners want to be debt-free and have peace of mind. After all, this is the time to enjoy life and not worry about money as much. When a decent retirement fund has been set up and most outstanding debts have been paid off over the years, families can concentrate on the mortgage so that they are completely debt-free when retirement begins. This will eliminate the need to make mortgage payments out of pension or retirement funds, and Social Security’s monthly allotment. After working hard for many years, having extreme financial constraints during retirement and emotional stress due to personal finances should be avoided.
Protecting Your Largest Asset – The stock market doesn’t always return 10%, or even constantly maintain a positive return at all. If you are risk-adverse and financially conservative, it may make more sense for you to invest in your home and pay it off to ensure you will always have a place to live. Diversifying your investments is not a sure way of protecting your assets.
Extra Money Later – The trade off when paying down any debt is less money now for more money later. When you have paid off your mortgage, you’ll have more discretionary income to spend on other things. Imagine how much money you could add to your retirement nest egg, stock portfolio, or savings account if you didn’t have any debt, including your mortgage.
Reasons Why You Don’t Want To Pay The Mortgage Off Early
Liquidity and Flexibility – Having cash in the bank has always offered me peace of mind – that if I lost my job, my business didn’t do well, the stock market crashed, I had a medical emergency, or had to incur a large expense unexpectedly, I could manage it. Even without an unforeseen incident occurring, investing all your extra cash into your home means you don’t have money to invest if other opportunities arise. A home is an illiquid asset, meaning that, if you needed money fast, you could not sell your home and convert the proceeds quickly.
Better Use of Cash, Higher Returns With Investment – As I mentioned at the beginning of this article, your mortgage interest rate is likely between 3 and 6%, assuming you have a fixed rate. If you could invest your excess cash or savings and get a rate of return higher than your mortgage costs, you would be better off making that investment and pocketing the difference. Unfortunately, any rate of return is never guaranteed when investing, so an investment option that has the potential to return greater than 6% based on historical returns does not guarantee future returns. As always, historical performance does not indicate a guarantee of future performance, and all investments have risks.
Tax Deduction – As you probably already know, the interest on your mortgage is tax-deductible. This means that the thousands of dollars in interest payments you make each year can be used to lower your taxable income, and thus your overall tax bill. It is one of the most common tax-deductions American households take advantage of.
Higher Interest Rate Debt – Many individuals rack up large credit card bills or unsecured loan debt over the years. It becomes easy to whip out that credit card at restaurants, fashion outlets, the grocery store, and travel agencies for that much-deserved break in your life’s hectic schedule. But what happens to this debt as time goes on? If the monthly balance is not paid in full every month, outrageous interest rates, ranging from 10% to 26%, keep adding up. Once you are trying to battle mounting debt with high interest rates, repayment will take a lot of discipline and time. Under these circumstances, allocate extra money to paying down this type of debt and skimping on luxuries until unsecured, high-interest debt is eliminated. Generally speaking, always pay off higher interest rate debt first.
Emergency Funds – There are many reasons to keep a mortgage on your home. The first and foremost reason is that you are unable to pay it off completely right now; couple that with potential refinancing options to pay off other debts or complete home repairs, and the original 30-year mortgage could be extended well into the future. Not only is the life of the mortgage getting longer, the homeowner is getting older, and income may be diminished in retirement. If you do not have a fund for emergencies, such as a potential job loss or natural disaster, then extra money that could pay off the mortgage early should be set aside in a savings account or safe investment option just in case.
401K Contributions and Retirement Funds – Many companies will match 401K contributions, allowing for a nice retirement fund to begin building. The more each employee contributes to his or her own retirement fund, the more your employer will fund as well (of course, this amount is capped at a certain percentage of your salary). At the moment, interest rates are very low, so it is the opportune time to contribute more monthly income towards your retirement nest egg.
Retirement – After working hard, purchasing a home, and paying your bills on time each month, you might seek the advice of a financial advisor to begin planning for retirement and the future. A few years ago, the financial advisor would have definitely encouraged homeowners to pay off their mortgage as quickly as possible. After all, there were children to put through college and trips to take during the retirement years. Maybe even a second home purchase as an investment or vacation home would be an option. The money used each month for the mortgage payment would come in very handy for all these expenses, but this old-school theory might not be the smartest option within the current financial situation.
College and The Future – Families that have teenagers headed for college should plan ahead, as a university education gets more expensive each year. Savings for college should begin when the child is very young, but this is not always possible, as new parents often barely have enough money to support the household. However, as careers grow and your income increases, funds that could be used to pay off a mortgage should instead be allocated to future education. In a similar manner, life insurance should be funded in case the unthinkable happens. Rather than putting money toward extra mortgage payments, future financial planning in case of an untimely death could be a higher priority.
There are many pros and cons to paying off a mortgage early. Most of the time, the choice is laid out for us, as we realize that other priorities in life have to come first. During the working years we can also deduct mortgage interest on tax returns, which helps a growing family keep more of their original income. Once finances are secure, however, reducing mortgage debt is an excellent option.