Does It Make Sense to Pay Off My Mortgage Early?
You’re more likely to be struck with lightning than you are to hold a winning lottery ticket, but there’s always someone who hits that magical combination of numbers. If you hit the jackpot — or run into more common cash windfalls like a big bonus or inheritance — one of your first instincts might be to pay off your mortgage balance.
On the surface, it might seem like a great idea to be mortgage-free for life, but before you plan your “debt-free home” party, you may want to look at your overall financial picture to make sure that’s the best use of your newly-found wealth.
In fact, it could actually cost you money in the form of higher tax liability, or lost opportunities for beefing up an underfunded retirement account. In this article, we’ll explore the things you should consider if you’re thinking about paying your mortgage off. We’ll cover:
- Reasons you should pay your mortgage off
- Reasons you shouldn’t pay your mortgage off
- Is paying off my mortgage early right for me?
- Who will benefit the most from having a mortgage
Reasons you should pay your mortgage off
A mortgage is a large loan and a long-term commitment. There are different risks associated with having a mortgage than with other types of debt.
The consequence for unpaid credit cards and personal loans might be a lot of nasty phone calls and a big dip in your credit score. However, these debts aren’t secured by your home, and don’t pose a threat to your shelter.
A mortgage is the only debt that could cause you to be homeless if for some reason you get behind on payments and can’t get caught up. Below are some of the best reasons to pay off your mortgage.
Get rid of your biggest monthly payment
Your mortgage typically makes up one of your biggest monthly expenses. If you plan to keep your home for the long-term, getting rid of the monthly payment sooner means more of your income can go towards beefing up your savings or retirement funds, or paying for more items in cash rather than using credit.
Remove the risk of losing your home to default
If you get behind on your mortgage payments, you could lose your home to a foreclosure. When you signed your note and deed of trust, you promised to repay the loan by specific terms.
While lenders will typically work with you if you fall on hard times, you could end up defaulting on your mortgage if you can’t come to an agreement. You could lose your home and end up with a major blemish on your credit — making it harder to obtain a mortgage or any other type of loan in the future.
There is safety and security in having a home with no financing or monthly payment. Although you’ll continue paying property taxes even after your mortgage is paid off, knowing that you don’t have any loans to pay off can be a stress reliever.
If you decide to downsize as you get older, you’ll have all of the equity in your home to purchase a smaller home and keep a cash cushion in your savings account.
Save money on interest
The longer it takes you to pay off a loan, the more you pay in total as interest adds up. Even if you have a great interest rate, over 30 years, you are still going to pay a lot of interest.
For example, if you take out a $200,000 loan for 30 years at a historically low rate of 3.75%, you’ll still end up paying $133,443.23 in interest. That could be several years of college education, or a healthy chunk of a retirement nest egg instead.
Pass on legacy to your heirs
You can provide future generations of family members with the safety and security of a free and available form of shelter. You may want to consider putting limits in your will on whether they can borrow against the property to ensure it is kept debt-free, or let them take ownership and borrow against the equity as they wish.
Reasons you shouldn’t pay your mortgage off
However, don’t be too quick to pay off your mortgage if you receive a windfall. There are a number of financial advantages to keeping your mortgage and using your newfound cash to meet your short- and long-term savings goals.
You don’t have an emergency savings account
If you don’t have a cushion of three-to-six months worth of your expenses in a savings account, then you should plan on funding that before completely paying off a mortgage. A good rule of thumb is to have even more — six to eight months of expenses in an emergency fund.
Your retirement account is underfunded
Whether you plan to retire to the golf course early or plan to work up until your 90s, it’s a good plan to have plenty of money saved for a relaxing or working retirement. For example, if the market delivers a 7% return, you can double your money every decade.
If you have a large lump sum of money to work with, contact a certified financial planner to discuss your options before you pay off your mortgage.
You’re concerned about your tax liability
Unless your current mortgage balance is over $750,000, there may be a substantial tax benefit to keeping your mortgage. As your income grows, the money you spend on mortgage interest every month acts as a hedge against your taxable income.
You may end up with a bigger tax refund every year, or be able to reduce your withholding so you take home a little bit more from every paycheck you receive. If you pay the loan off and your income is continuing to grow, you could be in for an unpleasant tax bill surprise when April of the next year comes around.
You want to avoid a dip in your credit scores
One of the components of your credit score is the mix of accounts you have. Your mortgage payment history provides support for your credit management history, so a sudden drop off in the loan balance may also cause a drop in your mortgage scores.
Is paying off my mortgage early right for me?
While everybody’s situation is different, some types of consumers benefit more than others by paying their mortgage off early. The following are characteristics of homeowners who can be helped the most.
Poor credit history borrowers
Most borrowers with credit scores of 620 or lower at the time they purchase a home end up with higher rates and payments. Borrowers who have a history of credit management problems may benefit from being free from a mortgage payment, allowing them to use the extra leftover income to pay for purchases in cash instead of borrowing with credit cards.
Borrowers who don’t like risk
It’s not hard to find someone who has a sad tale of money lost in the stock market. Money put into the market is never risk free, and if you have little to no stomach for the short-term roller coaster rides the markets can take you on, paying off your mortgage may be a better option.
Paying off mortgage debt is basically risk free, and consumers with a very low risk tolerance may feel better knowing they have a completely paid for their house, rather than wringing their hands as they open their stock or 401(k) portfolio report each month to see if it has gone up or down in value.
Who will benefit the most from having a mortgage
Some homeowners are better off having a mortgage, and we’ll explore who benefits the most.
For borrowers that don’t have a regular savings plan that includes having money auto-deducted to save for trips, holidays, or retirement, then having a mortgage is a good way to force savings habits. Even though a mortgage is a debt, a portion of every monthly payment goes towards principal, which means the loan is being paid off.
As the loan is paid off, your equity grows. This equity can act as a form of savings account, giving you an asset to borrow against through a home equity loan.
High income earners
The mortgage interest deduction has a bigger effect on high income earners’ tax liability than it does for low or moderate income homeowners. If you fall into this category, you’ll likely be able to deduct the maximum mortgage interest possible, and this could even push you into a lower tax bracket.
If you’re in a higher tax bracket, it’s best to check with a tax professional to avoid an unpleasant surprise with when your taxes are prepared next year.
It may make more sense to use the cash from a sudden windfall of cash to pay your mortgage down faster, and allocate the rest to a savings strategy. Switching from a 30-year to a 15-year mortgage will produce a higher monthly payment, but will save hundreds of thousands of interest over the life of a loan.
If you can budget the lump sum to cover the increase in payment, then you can use the balance to contribute towards additional retirement and emergency savings. The combination of paying your mortgage faster, while investing in the market may provide a better foundation for building wealth.