Should I pay off my mortgage early?
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When you own a home, the thought of paying off a mortgage over decades can be daunting. So, it’s natural to want to retire your mortgage as soon as possible. Before you decide to use an inheritance, raise or your savings to pay off your mortgage, it’s important to determine whether it really makes financial sense for you. In some cases, the amount you save when you pay off your mortgage early might not be more than what you would earn if you put those funds to work elsewhere. However, the peace of mind you get could make paying your mortgage early worthwhile.
Can you pay off your mortgage early?
If you purchased a home well within your budget or have had an increase in income over the years you likely have extra cash on hand and are wondering how best to use it. If you’re considering paying off your mortgage early, first contact your mortgage lender or servicer. Based on the terms of your loan, you could be subject to a prepayment penalty.
How much will a prepayment penalty cost me?
Generally, mortgage lenders are prohibited from imposing prepayment penalties on most home loans under the Dodd-Frank Act. While changes to Dodd-Frank have occurred in recent years, prepayment penalties are still subject to regulations.
If your mortgage is the exception to the rule, a prepayment penalty can only be assessed in the first three years. It’s capped at 2 percent in years one and two, and 1 percent in year three. So, if your outstanding loan balance in year two is $295,000 and you pay your mortgage off, the lender could charge a prepayment penalty of up to $5,900.
Paying off your mortgage early: What to consider
1. Will other investments beat paying off a mortgage early?
Is it better to pay off your mortgage or invest? Ultimately, it’s a personal decision, but investing could be more sensible.
“Sadly, the math tells us it’s almost always better to invest in other places than in your mortgage,” says Richard Bowen, CPA and owner of Bowen Accounting in Bakersfield, California.
Mortgage rates have risen over the last year but are still lower than the average long-term return of the stock market, so if paying off your mortgage early leads to a return equal to your interest rate, that return would likely be lackluster compared to the annualized return for the S&P 500 — roughly 10 percent over the last 90 years.
In addition to stock market returns historically being higher than average interest rates, how you invest your extra money can really net you more over time than paying off your mortgage early. Investing it into a tax advantaged account like a 401(k), traditional IRA, Health Savings Account, or 529 college savings plan will net you immediate federal tax savings, plus any market gains on your investment.
A potentially better use of the funds might be to take the cash you’d use to pay off your mortgage and leverage it into buying a cash flow-positive property like multi-family real estate or single-family homes that have the potential to offer higher long-term returns, Bowen points out.
Any choice poses a risk, however. Even after paying off your mortgage early, real estate prices could plunge, leaving you with a potential loss. Carefully consider which risks you’re willing to take. Ultimately, you might be better off not paying your mortgage off early.
“The thing is, no one can give you a guarantee on an investment,” Bowen cautions. “You can put your money in the stock market and lose it. You can put your money in real estate and it doesn’t perform as well as you expected it to.”
2. Will all your cash be tied up in the mortgage?
Before taking a large chunk of your wealth and using it to pay off your mortgage early, don’t forget to look at liquidity. Your home is considered a non-liquid asset because it can take months — or longer — to sell the property and access the capital.
“If you start paying down your mortgage too fast, you risk depleting your liquidity,” says Amanda Thomas, CFP, a client advisor at Mission Wealth in Santa Barbara, California. “The kind of liquidity you have is important, too.”
One approach 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, in addition to having money tied up in tax-advantaged retirement accounts and your home, you still have some liquid cash or other investments that are easy to convert to cash in a pinch.
Bowen suggests maintaining a cushion that protects you for at least six months before you consider using a large portion of your liquidity to retire your mortgage early.
3. How will you use the money if you don’t pay off your mortgage early?
Be realistic about what you’re likely to do with your money if you don’t use it to pay off your mortgage early. After the mortgage is paid off, will you actually use it to get ahead?
It might make sense, for example, to put the money into paying off your mortgage early if you struggle with keeping money in the bank. Your home can be a forced-savings tool, and making extra mortgage payments can save you thousands of dollars in interest over time, plus help you build equity in your home faster.
“The right thing to do is the thing you will do,” Bowen says. “All of this has to do with personal habits. If you’re going to blow through the extra money anyway, then it’s better that you put it into your house than spend it.”
4. How much do you value peace of mind?
Sometimes it’s less about the bottom line and more about peace of mind. If you own your home free and clear, that can provide benefits that can’t be measured in strictly financial terms. For many, eliminating a monthly mortgage payment ahead of retirement can provide mental relief when considering living on a fixed income.
“Personally, I’m paying down my mortgage,” says Thomas of Mission Wealth. “It feels good to have it paid off before retirement. It might not always make financial sense, but it offers peace of mind and it might allow for better budgeting.”
Another potential advantage is the ability to borrow against the equity in your home. Having a considerable amount of equity can allow you to establish a home equity line of credit (HELOC), providing a source of emergency income, as well as allowing you to make home improvements or make progress toward other financial goals.
Pros and cons of paying off your mortgage early
- Eliminates your monthly mortgage payment, freeing up extra funds for use in retirement
- Potentially saves you thousands of dollars in interest
- Offers a predictable rate of return, equivalent to the interest rate on the balance you’re paying off
- Provides peace of mind knowing you own your home outright
- Allows you to tap the equity in your home if you need money in the future
- Ties up a good chunk of your liquidity and net worth in your home, which might make it harder to access later
- No longer eligible for the federal mortgage interest tax deduction if you are still claiming it. Ever since the standard deduction was raised significantly in 2017 with the Tax Cuts and Jobs Act, fewer people itemize their deductions and thus can benefit from the mortgage interest tax deduction.
- Could miss out on potential higher returns from other investments
- Might not realize as much from your home as you had hoped if the market drops and you have to sell quickly
How to pay off your mortgage early
If paying off your mortgage early is right for you, here are some strategies to do it:
- Make biweekly payments. One way to get started with making extra mortgage payments is to set up a biweekly schedule. This amounts to making a full extra monthly payment each year and can reduce the time spent with a mortgage. Starting with biweekly payments can help you get ahead on your mortgage while allowing you to keep working toward other financial goals.
- Make extra mortgage payments each year. Similar to making biweekly payments, you can simply make an extra mortgage payment once a year, or pay an additional amount each month ($250 more, for example) on top of what you already pay.
- Make sure that your extra payments go towards principal and are not credited as future monthly payments by speaking with your lender and following their process for making principal payments.
- Refinance to a mortgage with a shorter term. If you stand to get a lower interest rate, refinancing to a 15-year mortgage means you’ll pay off the loan sooner. Keep in mind that even with a lower rate, you could be paying more each month, since your payments are now spread out over a shorter period of time.
Who is a mortgage payoff best for?
Paying off a mortgage early is often a consideration for homeowners looking to retire early or stay in their homes for an extended period of time.
Ultimately, the decision comes down to personal preference and whether the benefits outweigh the costs. Consider any prepayment penalty and the potential tax consequences. Also, conduct an inventory of your finances to determine if it’s more sensible to use the funds elsewhere, like to eliminate high-interest debt.
Alternatives to prepaying your mortgage
If you’re not sure if you should pay your mortgage off early, consider these other options to maximize your dollars:
- Refinance your mortgage get a lower interest rate and possibly reduce your monthly payment amount.
- Invest in the stock market to increase your earning potential.
- Increase your retirement savings by making higher contributions.
- Fund your child’s education by contributing to an education savings plan.
- Build (or add to) an emergency fund.
- Pay off high-interest credit cards, personal loans or student loan debt to save a bundle in interest.
When considering whether to pay off your mortgage early, it’s important to figure out what works best for your situation and is most likely to help you reach your short- and long-term financial goals. Sometimes, with financial planning, it’s not a straight assessment of what’s best by the numbers. People want to feel good about where their money is going — no matter what the spreadsheet says.
For some, owing money causes stress, and paying off a mortgage early can bring peace of mind. For people nearing retirement, a paid-off mortgage means they have that much more free cash flow from their fixed income when they stop working.