Should You Pay Off Your Mortgage Early?

Should you pay off your mortgage early? I received two questions about this last week and it’s one that many people wonder about, whether they’re thinking of making extra payments each month or paying it off all at once with a lump sum payment. After all, who doesn’t look forward to the day when they don’t have to write that big check to the mortgage company every month? On the other hand, there might be better uses for your money, especially when mortgage rates are so low. No wonder the experts are split. Let’s take a look at some of the considerations in deciding whether it makes sense for you:

How much would you be saving on your mortgage?

The answer for most people is not a whole lot. That’s because interest rates are still near record lows and you can deduct that interest from your taxes. For example, if you have a 4% mortgage rate and you’re in the 25% tax bracket, your after-tax rate can really be about 3%.

If your rate is still high, you may want to consider refinancing instead. Thiscalculator can help you determine how long it would take to recoup any costs you may pay in a refinance. But even if you’re stuck with a relatively high interest rate because your credit isn’t so great or your home is underwater or if you don’t benefit much from the tax deduction, you still need to compare your savings with the other following options available to you with that money.

Do you have sufficient savings for emergencies?

It won’t do you much good to pay down your mortgage if you may have trouble making the remaining mortgage payments should you lose your job down the road. A rule of thumb is to have between 3-12 months worth of necessary expenses somewhere safe and accessible like a savings account or money market fund. The exact amount can depend on how secure your household income is.

Some people think that paying down their mortgage can reduce their need for emergency savings since they can borrow against their home equity, but there are a couple of problems with this. First, as we’ve learned over the last few years, home equity can drop just like the stock market. Second, even if you have plenty of equity, your mortgage company can cancel your home equity line of credit at any time and they’re most likely to do it right when you most need the money. Think of home equity as a potential low cost source of credit for things like home improvements and college funding but not as your emergency fund.

Do you have high interest debt?

Your mortgage is generally considered to be “good debt” and there’s a reason for that. The average 30-yr fixed rate is a little over 4% and rates for 15-yr and ARM loans are even lowerCompare that to the average interest rate on a credit card with a balance, which is over ten percentage points higher. Other debt like payday loans can be much higher. If you have any of this “bad debt,” paying it off first should be a priority simply because it’s costing you so much more in interest.

Are you taking full advantage of your retirement accounts?

At the very minimum, you want to make sure you’re getting your employer’s full match before making extra mortgage payments. Otherwise, you’re leaving that free money on the table.  Even beyond that, you’re still often better off contributing to your retirement plan because of the tax benefits and the potentially higher returns on your investments than what you’re probably saving on mortgage interest. A 2007 study by the Federal Reserve found that the 38% of U.S. households currently paying down their mortgage at the expense of retirement plan contributions are losing benefits of between 11% to 17% depending on their choice of investment. While the benefit would be smaller, this would apply to investing in stocks in taxable accounts too since their historical long-term annualized returns have averaged between  8-10%.

How conservative are you?

None of the above (except the employer match) applies if you’re going to put your retirement savings into a money market fund earning less than 1%. If you’re very conservative and unwilling to take any risk, paying down your mortgage early may be your best option since it’s like getting a guaranteed tax-free return equal to the mortgage interest rate (less any applicable deductions). I don’t know about you, but I don’t know anything paying a guaranteed 3-4% tax-free right now.

Just be sure that you can actually retire with that low of a return on your savings. Some people can retire comfortably on just Social Security and pension income once their mortgage is paid-off while others will have to save more. What you don’t want to do is wait until the market is doing better to become more aggressive since that’s the recipe for buying high and selling low.

Are you in or approaching retirement?

The calculations look a little different at this point. If you’ve had the mortgage for a while, you’re probably paying little or no interest so you’re not really benefiting from the tax deduction. You also won’t benefit as much by investing the money instead since your investments are likely to be more conservative and if you’re retired, you’re not eligible to make tax-advantaged retirement plan contributions anymore. In fact, you may need to make withdrawals from those accounts just to make the mortgage payment. If you have 5 years left on your mortgage, who knows how well the investments in those accounts will do in the next 5 years?

For all these reasons, it may make sense to pay off the mortgage early at this time. There are a couple of other things to keep in mind. First, if you’re making large withdrawals from retirement accounts, you may want to space them out over 2 or more years to avoid having them taxed at a higher tax bracket. Second, if you’re paying it off over a 5-7 yr period, it could make sense to refinance to a 5/1 or 7/1 ARM so you’ll pay less interest during that payoff period. Just make sure that you’ll save more in interest than you’ll pay in refinancing costs.

How would being mortgage free make you feel?

Those are all the financial considerations. However, there’s an emotional component to this too. After examining the financial impact of your decision, you may decide the financial loss is worth the peace of mind you’d get from being free of your mortgage a bit earlier. In that case, there’s nothing wrong with your decision as long as it’s an educated one. 

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Sherif Nathoo

Sherif Nathoo

Sales Representative
CENTURY 21 Leading Edge Realty Inc., Brokerage*
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