Should you pay off your mortgage early?
When you own a home, the thought of a mortgage hanging over your head for decades can be daunting for many people — and it's natural to want to pay off your mortgage as soon as possible.
But before you decide to use an inheritance, a raise or your savings to pay off your mortgage ( or e ven before you decide t o make e xt r a payments), it's important to take a step back and determine whether it really makes financial sense for you.
In some cases, the amount you save on i nterest when you pay off your mortgage early might not exceed what you would earn if you put the money to work elsewhere. On the other hand, sometimes it's not about the return on other investments and more about peace of mind or freeing up cash fl ow for other opportunities. Here's what you need t o know a s you decide whether t o pay off your mortgage early.
Can you pay off your mortgage early?
If you're considering paying off your mortgage early, first contact your mortgage lender or servicer. Based on the terms of your loan, you might find out you're subject to a prepayment penalty i f you pay off your mortgage sooner than your payment schedule spells out, or that you can only make payments within certain parameters. Knowing this information upfront can help you map out a payoff plan that works for you and your lender or servicer.
What to consider
1. Will other investments beat paying off a mortgage early?
Your biggest consideration might be whether to pay off y our mortgage or i nvest . What if, instead of putting money into getting rid of your mortgage early, you invested the cash elsewhere?
“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 are at alltime lows, so if paying off your mortgage early leads to a return equal to your interest rate, that return likely would be lackluster compared to the annualized return for the S&P 500 — roughly 10% over the past 90 years.
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 multifamily real estate or single-family homes that have the potential to offer higher long-term returns, Bowen points out.
Any choice is a risk, however. Ultimately, you might be better off not paying your mortgage off early.
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, a client adviser at Mission Wealth in Santa Barbara, California. “The ki nd 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.”
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.
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. 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.
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.
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( HE LO C ), 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 PROS
•Eliminates your monthly mortgage payment, freeing up cash flow that can be useful, especially during retirement.
• Saves you money on interest, potentially thousands of dollars.
• Can receive a predictable rate of return, equal to the interest rate on t he balance you're paying off.
• Grants peace of mind knowing you own your home outright.
• Can tap the equity in your home if you need money later.
CONS
• 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.
• 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.
Tips to pay off your mortgage early
If you decide that it makes sense to pay off your mortgage early, be careful not to put your other financial goals at risk. Here are some tips.
• Pay off high- interest debt before making extra mortgage payments: Other debt like credit card balances might have much higher interest rates than your mortgage, so if you pay off your mortgage early instead of tackling that, 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. It might be wiser to get rid of other debt first.
•Make sure you' re investing for retirement: Make sure you' re putting money into a tax-advantaged retirement account, like 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 t he time you retire can be a good combination.
• Build up an emergency fund: As Bowen points out, 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, such as switching to a 15- year loan from a 30- year mortgage. You' ll be making higher payments each month, but it's a way you can save on interest and still be out of debt sooner.
•Consider making 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.
•Check for a prepayment penalty: Don' t forget to check for mortgage a prepayment penalty. 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.