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, raise or your savings to pay off your mortgage, (or even before you decide to make extra 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 interest 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 flow for other opportunities.
Here’s what you need to know as you decide whether to pay off your mortgage early.
Will other investments beat paying off a mortgage early?
The biggest consideration is whether to pay off your mortgage or invest. What if, instead of putting money into getting rid of the 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.
Many mortgages today have rates of 3.5 percent to 5.5 percent, so if paying off your mortgage early leads to a return equal to your interest rate, that return is somewhat lackluster. Compare that to the annualized return for the S&P 500 — roughly 10 percent over the last 90 years.
Additionally, Bowen points out, you could take the cash you’d use to pay off your mortgage early 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.
“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.”
Any choice is 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. You might be better off not paying your mortgage off early.
Will all your cash be tied up 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 advisor at Mission Wealth. “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.”
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 chunk of your liquidity to retire your mortgage early.
How will you use the money if you don’t pay off your mortgage early?
Next, be realistic about what you’re likely to do with that money if you don’t use it to pay off your mortgage early. If you don’t put that money toward making extra mortgage payments, will you actually use it to get ahead?
Bowen points out that it might make sense to put the money into paying off the mortgage early if you struggle with keeping money in the bank.
“The right thing to do is the thing you will do,” he 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.”
A 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.
How much do you value peace of mind?
Sometimes, though, it’s less about the bottom line and more about peace of mind. Data from ATTOM indicates that 34 percent of homeowners have 100 percent equity in their homes, and that can provide benefits that can’t be measured in strictly financial terms.
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,” Thomas of Mission Wealth says. “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 large amount of equity can allow you to establish a home equity line of credit (HELOC), providing a source of emergency income, as well as make home improvements. HELOC interest rates are near historic lows, and if the money is used to make repairs or build an add-on, the money might be tax-deductible.
Pros and cons of paying off your mortgage early
Eliminate the monthly amount going toward your mortgage, freeing up cash flow that can be useful, especially during retirement.
Save money on interest, potentially thousands of dollars.
Receive a predictable rate of return, equal to the interest rate on the debt you’re paying down.
Enjoy peace of mind, know you’re debt-free.
It’s possible to tap the equity in your home if you need money later.
Ties up a good chunk of your liquidity and net worth in your home, and it might be harder to access it later.
If you’ve been taking the mortgage interest federal tax deduction, you’re no longer eligible.
It can be difficult to sell the home quickly if you lose a job or if there’s an emergency and you need money fast.
You miss out on the potential for higher returns from other investments.
If the real estate market drops just when you need to sell you may not realize as much from the home as you had hoped.
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.
Pay off high-interest debt before making extra mortgage payments: Other debt, like credit cards, may have much higher interest rates. When you pay off your mortgage early before tackling other debt, you could end up behind. Credit card debt, perosnal loans and even car loans usually cost you more and the interest isn’t tax-deductible. So, before putting money into paying off the mortgage early, get rid of the other debt first.
Make sure you’re investing for retirement: When deciding whether to pay off the mortgage or invest, don’t forget to consider 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 the 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 make higher payments each month, but it’s a way you can save on interest and still be out of debt sooner.
Consider making bi-weekly payments: One way to get started with making extra mortgage payments to set up a bi-weekly schedule. This amounts to making a full extra monthly payment each year and can reduce the time spent with a mortgage. Starting with bi-weekly payments can help you get ahead on your mortgage while allowing you to keep working toward other financial goals.
Check for prepayment penalties: Don’t forget to check for mortgage prepayment penalties. 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.
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 the best by the numbers. People want to feel good about where the money is going — no matter what the spreadsheet says.
For some, owing money causes stress and paying off the 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.
“My wife likes having money in the bank, whereas I’d rather invest it,” says Bowen. “But if money is a tool, then that money is buying her happiness, so it’s working.”
With reporting by Bankrate’s Natalie Campisi.