When it comes to monthly expenses, housing is often our greatest expenditure. Americans spend an astonishing average of 37% of their take-home pay on housing. That’s the average. Many people spend even more!
Sometimes it just needs to be done…it’s unavoidable. But it’s a monumental decision that most people face – do I pay off my mortgage as quickly as possible? Or not?
As with anything, there are benefits as well as drawbacks to paying off a mortgage early. Before you decide to divert funds from your 401k or savings account, here are some things to consider:
You pay less interest. Find a decent calculator on the internet (here’s one example) to show you how this works. The cost of interest on a loan over 3o years could almost double the amount that you end up paying. Satisfying the loan sooner obviously reduces the amount of interest you end up paying.
It frees up cash flow. Not having a mortgage payment means you have more resources for other things. If you are investing that extra money, you may even tend to be more aggressive with your strategy.
You’ll eventually no longer need to make payments (lower expenses in retirement). Who wouldn’t want to retire and not have a mortgage payment?
Peace of mind. People definitely feel less stressed when their house is paid for. It’s less of a cloud over their heads.
You may have options to cash-out refinance, or take Home equity loan if funds are needed down the road. This is not always available nor achievable, but it could free up some cash in some cases.
You’d lose the interest deduction. For those that itemize on their taxes, you can potentially lose a great tax advantage – getting to deduct it on your tax return.
Loss of liquidity. Money puts towards a house is normally not readily available. What if you need funds for an emergency or other important need?
Potential prepayment fee. Within the past 10 years, mortgage reform has decreased the number of loans that do have a prepayment penalty. However, it’s a big consideration and worth checking to see if your loan includes this fee.
Impact on credit. Mortgage loans improve your creditworthiness. Payment history, length of the account, and variety of debts all influence your score. The early payoff would work against you.
You might be missing out on investment returns. If you were to compare the average stock index return over the years, versus the average mortgage rate, you’d see many people were better off paying the mortgage minimums while investing the difference. No one can promise future returns, but the thought is “be your own bank” (here’s one of many hypotheticals out there).
Loss of an inflation hedge. With fixed-rate mortgages, the bank assumes the risk by making your payment flat. They do not increase it with inflation, like most other costs of things (healthcare anyone?) over time. So in a practical sense, why hurry to pay off something that becomes cheaper over years?
What to do:
As a general rule, the higher the mortgage interest rate, the more it makes sense to pay it off sooner. That doesn’t mean it’s a no-brainer, but it’s one factor.
The same goes for if you are not investing money and not getting a return on the cash. It would typically be better to pay off mortgage balances if the mortgage rate is higher than what you are earning on the cash.
Do yourself a favor – run the numbers (aka use a mortgage calculator). Do some number crunching and determine the impact of making additional payments, versus refinancing, versus paying the mortgage off completely. Here is one such calculator.
Also, determine your opportunities. What else would you, and could you, be doing with the cash that was NOT going towards your mortgage? How safe or guaranteed are those other options?
Another big determinant is your tax situation. Are you currently benefitting from the mortgage interest deduction? Even if not, laws can change. They have changed recently, in fact, which worked against most homeowners.
However, the tax deduction could always come back into play. Additionally, we all know you can get tax advantages by putting money into a retirement account and letting it grow for many years.
Last but not least: talk it over with a professional. Typically your accountant would be a good person to discuss this with, as well as a financial planner. CAVEAT: Be aware that certain salesmen could steer you away from paying down your mortgage for fear they won’t be able to sell you an investment product. Go with people you trust to give unbiased advice.
In the end, the decision to pay off your mortgage faster is not always cut-and-dried. Each individual’s situation has unique circumstances, as well as various attitudes towards debt. One’s tax, retirement, cash flow, and credit situation all warrant careful consideration and evaluation.
One potential “Best of both worlds” scenario: refinance (so that you have lower payments/interest) and make extra payments such that you pay it off in a shorter period. At least then, you have more flexibility and can save more in your retirement accounts. And in that scenario, you aren’t committed to paying it down faster – but you’ll have an option to do so as your cash flow allows.
For most, find a nice equilibrium by funding both your retirement (and investing) while gradually paying the mortgage over time. This oftentimes works as a nice compromise.
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