Smart to pay off house early? Maybe not

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Dear Debt Adviser,
I am scheduled to make my last mortgage payment in May 2013. My monthly payment is $1,473. My question concerns whether I should try to get rid of this debt as soon as possible. I am in a position to pay an extra $100 a month on the mortgage. The mortgage’s remaining balance is about $32,000. I am 64 and plan to retire in November 2013, or about six months after the mortgage is now scheduled to be paid off. So my question is this: Is making extra payments on the principal a wise move? Thanks for your help.
— JJ

Dear JJ,
I understand why you might want the satisfaction of paying off your mortgage early. For one thing, it means you can hold on to almost $1,500 per month. However, I think in your case it might be wiser not to. Here’s my reasoning.

Many homeowners are indoctrinated to pay off their mortgage as quickly as possible. The financial coach in me finds this understandable. But in general, it is not a good use of funds as long as carrying the mortgage is part of an overall financial plan. My take: Mortgages are cheap money and tax-advantaged to boot. To me, it’s like saying, “Let me pay back this tax-sheltered low-interest loan so I can pay more taxes and pump money into a largely illiquid investment.” I believe you might be better off saving that $100 per month instead. Let’s do the math.

You don’t give the specifics of your mortgage. But deductive reasoning would suggest you got an original mortgage of about $225,000, and going back 28 years, it’s reasonable to estimate your interest rate at about 7 percent.

Based on my calculations, the $100 per month that you would make as an extra principal payment on your mortgage would only save you approximately $162 over the next two years. Furthermore, it would only pay off your mortgage one month earlier.

The reason is, by the time you get to the last two years of most mortgage loans, the majority of your payment already goes toward the principal. You’re not paying much interest. For instance, with the mortgage described above, you’re only paying around $200 per month in interest and the rest is going to principal. In contrast, when your mortgage started, it was approximately $200 toward principal and the rest for interest.

If you had started making additional $100 principal payments when you had 20 years left on a 30-year mortgage, then you would have saved almost $24,000 and paid off the loan two years and five months faster. This late in the game, however, the difference would be negligible.

So my recommendation is to save the $100 or more each month until you retire. If you don’t already have an emergency savings cushion (six to 12 months’ worth of living expenses for those of us working, but less for retirees), stash away the savings for that proverbial rainy day. This will give you some flexibility for unexpected expenses when you have a fixed income.

Should you already have an emergency savings cushion, which I hope you do, then you can have some fun with the $2,400. How about using the money you set aside for a retirement celebration? You and your significant other could take a cruise, visit friends or purchase something that you have been wanting but never bought.

The last thing I’d like for you to keep in mind is that your home could provide you with additional income should you ever need it during your retirement. If you find that your income is not sufficient at some point, do some research on a reverse mortgage. A reverse mortgage, in many cases, can be a much better fix for increasing your income than using credit.

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