Most homeowners want to own their homes free and clear. For some, that means using a raise, inheritance or savings to pay off their mortgage early. But this seemingly responsible move may not always be in your best financial interest.
According to financial experts, paying off your mortgage early actually comes with a cost to your bottom line. The reason lies in simple math: the amount you’ll save in interest likely won’t exceed what you would earn in other long-term investments, such as stocks and real estate.
For investments to make more sense than paying off a mortgage early, the annualized rate of return over a certain number of years would only need to make more than the mortgage interest. And since most people are sitting on relatively low mortgage rates, between 3.5 to 5.5 percent, beating that rate isn’t tough.
The average annualized return for the S&P 500 index over the past 90 years is roughly 10 percent. Using the cash to leverage more real estate, such as multifamily properties and single-family homes, is another long-term investment that will likely offer higher long-term yields compared with paying off your mortgage, says Richard Bowen, CPA and owner of Bowen Accounting in Bakersfield, California.
It’s not an easy call
However, it’s important to work with a financial advisor before you invest so you can fully understand the risks and benefits involved, Bowen adds. Although history tells us that these investments outpace saving on your mortgage interest rate, they can be risky.
“Sadly, the math tell us, it’s almost always better to invest in other places than in your mortgage,” Bowen says. “The thing is no one can give you a guarantee on an investment. 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.”
Indeed, if you, like thousands of others, had invested in Las Vegas real estate before the 2008 financial crisis, you’d have lost your shirt and pants, too, when prices plunged 60 percent, nearly twice the national rate.
Maintaining some liquidity is essential
Financial experts agree that it’s important to have a portion of your net worth in liquid assets. These are assets that can be converted into cash quickly such as stocks, marketable securities, mutual funds, U.S. treasuries and bonds. A house is considered a non-liquid asset because it can take months, or longer, for a homeowner to sell the property.
Liquidity is important in times of economic downturns and personal emergencies. Its primary function is to be an easy way to access cash when you need it. If your cash is tied up in a house or retirement accounts (which can be expensive to draw from), you could end up having to borrow money in a pinch.
“If you start paying down your mortgage too fast you risk depleting your liquidity. The kind of liquidity you have is important, too. You don’t want too much cash tied up in retirement funds because you can get slammed with fees if you have to withdraw early,” warns Amanda Thomas, a client advisor at Mission Wealth.
If you withdraw money from an IRA before you turn 59 ½, you will pay a 10 percent penalty and income taxes on the amount you withdraw. After you turn 59 ½ you will not have to pay the penalty fee on withdrawals but you’ll still be obligated to pay income taxes. Depending on how much you withdraw, this might be pushed into a higher tax bracket, which could mean a bigger bill from Uncle Sam come tax time. Find out the minimum distribution from your retirement accounts here.
If paying off your house is more valuable to you than earning a few dollars more in stocks, be sure you have a six-month emergency fund saved before you commit a big chunk of cash to your mortgage payment, Bowen advises.
Families should strive to have a minimum of three months after-tax wages in the bank and low-income earners should aim for at least $1,000 saved before putting extra toward a mortgage payment.
“From a personal finance perspective, you free up monthly cash when you pay off your house, but you remove a whole bunch of cash to do that. As long as what you’re giving up still leaves you with the pad that protects you for six months to one year then that’s okay,” Bowen says.
Poor savers might be the best pay-off candidates
Financial planning is a process that’s unique to every individual. Spending habits, timelines, how much risk you’re willing to assume — and how much you’re okay losing, as well as your financial and personal goals are all elements that go into an effective strategy.
If someone tends to spend or has trouble keeping money in the bank, then that’s a behavior that’s not likely to change so it’s important to plan around it, Bowen points out.
“The right thing to do is the thing you will do. 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,” Bowen says.
Paying off your mortgage early will decrease your total mortgage interest, which could save you thousands, as well as help you build equity faster.
Homeownership offers peace of mind
According to ATTOM data, 34 percent of homeowners have 100 percent equity in their homes. For many people, including Thomas, owning your home offers benefits that can’t be tallied on a computer.
For folks nearing retirement, eliminating that monthly mortgage payment can be a mental relief when they’re facing a fixed income.
“Personally, I’m paying down my mortgage. 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,” Thomas says.
Homeowners can also borrow against the equity in their home by way of a home equity line of credit, or HELOC, in case of emergencies or to make improvements to their home. HELOC interest rates are still historically low and if you use the funds to add on or make repairs to your home, then the money is tax deductible.
The important thing is for people to identify their financial goals and to allocate their money appropriately. Although financial planning seems like an exercise in logic, it’s often ruled by emotion. People want to feel good about where there money is and that doesn’t always line up with what a spreadsheet might recommend.
For some people, owing money causes stress, so getting rid of debt is a better use of funds than keeping the debt in order to earn extra in investments.
“My wife likes having money in the bank whereas I’d rather invest it. But if money is a tool, then that money is buying her happiness, so it’s working,” Bowen says.
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- Home equity line of credit (HELOC) vs. home equity loan