Does It Make Sense to Pay Off My Mortgage Early?
Wondering if you should pay off your mortgage ahead of schedule? The answer seems like a no-brainer; being free of such a huge debt burden would probably decrease your cost of living in a major way. A 2012 study put out by Zillow found that 29 percent of U.S. homeowners (a whopping 20.6 million) own their homes outright.
But it’s typically a more complicated decision than it might seem on its face, especially when you factor in how getting mortgage-free will impact things like your tax situation, credit score, investment returns and cash reserves.
There are a lot of moving parts, to say the least. We’re here to demystify what it means to pay off your mortgage early, from the obvious perks to the hidden risks.
“There isn’t an automatic right or wrong answer,” says certified financial planner Andrea Blackwelder. “There are the cold, hard numbers to consider, then the emotional side of how you feel about being mortgage-free.”
Here’s a look at the biggest ways your mortgage impacts your financial life.
|Keeping your mortgage or paying it off early|
|How it impacts….||Paying off your mortgage early||Keeping the mortgage|
|Your debt||Being debt-free is enticing; the median monthly mortgage payment for homeowners is $1,015, according to a 2011 U.S. Census Bureau report. Eliminating your mortgage means freeing up significant cash you can then invest and grow.||Mortgage debt is different from, say, credit card debt in that it’s an investment in an appreciating asset (your home). If you stumble on financial hard times, you may be able to use the equity in your home to unlock cash via a home equity loan, HELOC or cash-out refinance.|
|Your taxes||Saying so long to your mortgage, in some cases, can be tax-efficient. (More on this in a minute.)||For the moment, the interest you pay on a mortgage can be tax-deductible, although that could change with pending GOP tax reform legislation.|
|Your budget||To get rid of your mortgage early, you’ll have to direct extra money toward your loan. This could affect your ability to save for other goals. Our experts say that accelerating your mortgage payments should never be at the expense of your emergency fund or retirement savings.||Keeping your standard loan payment, instead of accelerating it, means that you can direct more money toward things like your emergency fund and retirement savings.
If you have a low interest rate on your mortgage, some argue that it makes more sense to keep it and direct your extra money toward investment accounts, which could reap better returns.
|Your credit score||Getting rid of your mortgage could impact your credit score because it closes the account on your credit report, which reduces your access to credit. This is concerning if you don’t have many other open accounts. Most of us do, though, so the impact on your credit score is apt to be minor.||As long as you’re making consistent, on-time payments, keeping your mortgage is good for your credit score because it reflects a positive payment history. This makes up 35 percent of your FICO score.|
|Your home equity||The more you pay down, the more home equity you have. If you’re currently paying PMI (private mortgage insurance), reaching 20 percent equity typically eliminates it; an encouraging milestone on your way to being mortgage-free. After paying off the whole loan, you’ll have 100 percent equity, which means you’ll owe nothing to the bank if you decide to sell.||Even if you aren’t in a hurry to pay off your mortgage, establishing equity is important—how much equity you have plays a major role in your ability to qualify for a home equity loan or HELOC.
This is no small thing, as it could provide a serious financial cushion in the event of an emergency.
Reasons not to pay off your mortgage early
Your emergency fund needs some work
Certified financial planner Allan Roth is generally a fan of paying off your mortgage early, but your cash reserves might change the game.
“If I tell you to pay off $30,000 that’s left on your mortgage, and then you lose your job and you don’t have any other liquidity somewhere else, then that could backfire,” he told LendingTree.
But if you have a solid emergency fund that you can tap relatively easily, Blackwelder says it changes things. This is precisely why she doesn’t suggest supercharging your mortgage payoff unless that emergency fund is locked and loaded with three to six months’ worth of expenses. This way, you aren’t so laser-focused on paying off your mortgage that you cut yourself off from the ability to access cash reserves if you need it.
Remember: Having good credit and around 20 percent equity in your home generally opens the door for home equity loans and HELOCs.
Let’s say after paying all your bills, you have $500 left over each month to use as you wish. Before you dial up your mortgage payments, funnel that $500 directly to your emergency savings until it gets to a safe level. This should help offset the risk.
You have higher-interest debt
Before going after the mortgage, compare the interest rates on all your debts. If you’re currently battling credit cards, student loans or other accounts with rates that are higher than your mortgage loan, it’s in your best interest to tackle those first.
“If you have, let’s say, 18 percent credit card debt that isn’t tax-deductible, that’s far better debt to pay off,” says Roth.
In a nutshell, maintaining higher-interest debt in order to eliminate your mortgage faster will cost you more over the long run, negating any potential benefits.
You don’t have a lot of other credit
Eliminating your mortgage loan reflects as a closed account on your credit report, which could affect your credit score because it reduces your available credit.
Blackwelder says this impact to your score is usually pretty nominal, unless you don’t have a lot of other open accounts. In addition to your available credit and payment history, FICO also considers your mix of credit and the length of your credit history when determining your score.
The good news is that there are plenty of other ways — other than having a mortgage — to build your credit. Using credit cards responsibly (i.e. not carrying a balance and keeping your credit utilization ratio low) is a great approach. Secured credit cards are another option.
You rely on the short-term tax deduction
If you’re a homeowner, the interest you pay on your mortgage translates to a deduction come tax time (though as of this writing, legislation that would reform the tax code and potentially remove the mortgage interest tax deduction is pending).
“The interest that’s paid on the mortgage is sometimes the biggest itemized deduction for taxpayers,” says Blackwelder. “Once the mortgage is paid off, you no longer have the deduction, so that could really increase your tax liability.”
You’re behind on retirement saving
When toying with the idea of paying off your mortgage early, the status of your nest egg should come into play. If funneling all your extra money toward your mortgage loan means neglecting your retirement savings, your plan could backfire.
“Sometimes home equity maybe isn’t working as hard for you as other assets could be,” says Blackwelder.
“If the long-term return in the stock market is 8 percent, as an example, and the increase of your home value on a year-to-year basis is 4 percent, one would argue that having more money in your retirement account does you more good than having more money in your home equity.”
It’s worth noting, however, that it’s all subjective. If you have an emergency fund, no other higher-interest debt, and you’re at least kicking in enough to your 401(k) to get an employer match, which is essentially free money, hitting the mortgage hard until it’s paid off makes sense while mortgage rates are lower than you can earn on a high-quality bond or CD.
After the mortgage is paid, Roth suggests then taking whatever you were spending on it and automatically redirecting it toward your retirement savings, whether that be a 401(k), IRA or investment account.
Reasons you might pay off your mortgage early
It could be a wise tax move
When considering the tax implications of paying off your mortgage early, missing out on the interest deduction is typically the first thing that comes to mind. But it could actually be more tax- efficient to eliminate the mortgage.
Roth says that paying down (or off) the mortgage is at least tax-neutral — and typically more tax-efficient — because the person may not be getting the full mortgage interest deduction anyway.
Low-income earners may be using part of the interest just to get to the standard deduction. Meanwhile, high-income earners may be getting phased down on some of that interest deduction.
What’s more, high-income earners may also be paying a 3.8 percent Medicare tax on bond or CD interest.
It frees up monthly cash flow
No longer having a mortgage will likely save you thousands of dollars per month. (Again, Roth suggests automatically investing this money.) But if you enter a tough financial time, like a stint of unemployment, your cost of living could be so low that your emergency fund is better able to absorb the short-term blow. Of course, this also underscores the importance of having liquid cash reserves at the ready.
Looking ahead to when you retire, entering your golden years mortgage-free will also enable your nest egg to take you a lot further since you will have eliminated such a major monthly bill.
How to pay off your mortgage early
There are a few ways to maximize your efforts. Blackwelder says to begin with first making sure you have the best mortgage possible. If, for example, you have a 6 percent, 30-year mortgage, it pays to refinance before accelerating your payments.
“There’s no sense in swimming upriver,” she says. “Today’s rates are somewhere between 3.5 percent and 4 percent.”
Refinancing into a shorter-term loan will also mean that more of your payments will go toward the principal. Just check to see if you’ll be hit with a prepayment penalty from your mortgage lender. If you’re ready to move forward with paying off your mortgage early, making biweekly payments might make for a great approach.
This is when you divide your monthly payment in half, then make one payment in the middle of the month. You’re basically making part of your payment a smidge early, which shortens your mortgage term and reduces how much you’ll pay in interest.
If your budget allows for heftier payments, Blackwelder says you can also round up to a comfortable number and make that your automatic monthly payment. So instead of paying $1,550 a month, you could round up to an even $2,000 that’s automatically withdrawn from your checking account. You can also take cash windfalls like tax returns and work bonuses and apply them directly to your principal balance.
No matter your strategy, our experts recommend that you continue kicking into your retirement funds. The takeaway is that you don’t want to be so focused on the mortgage that your quality of life and/or other savings goals suffer.
Questions to ask yourself before paying off your mortgage early
To summarize, let’s break down what you need to consider before eliminating your mortgage ahead of schedule:
- Is your emergency fund locked and loaded with three to six months’ worth of expenses? You want to make sure you can access cash should disaster strike.
- Do you have any higher-interest debt? If so, it makes more sense to knock these balances out first to save you the most money over the long haul.
- Are your retirement savings on track? At the very least, aim to contribute enough to get an available employer match. If you don’t have a 401(k), continue regularly contributing to your retirement, whether that’s through an IRA or an investment account.
- Will accelerating your mortgage payments make you unable to contribute to other savings goals? Whether it’s saving for your child’s college fund or a dream vacation, you don’t want to be so hardcore about your mortgage that other parts of your financial life suffer. Blackwelder says it best: “Having a debt-free home in retirement, but no money saved for other essentials, doesn’t make good sense.”
What to do once you pay off your mortgage
Recently crossed the mortgage finish line? If so, good for you! But your work isn’t done. As Roth highlighted, you should take whatever you were paying on it and instantly invest it. This is also the time to start dialing up any other long-term savings goals. This could include college funding or any other large purchase. But, far and away, retirement should be number one.
“We can usually get loans for college, but it’s very difficult to obtain a retirement loan; I’ve never seen one available!” says Blackwelder.
At the end of the day, there’s no clear-cut answer
Deciding whether or not to accelerate your mortgage payoff is rarely simple and clear. On one hand, heading into retirement without a mortgage payment could make your golden years a whole lot easier. On the flip side, if you currently have a super-low interest rate, your money might be better spent going into your 401(k) or investment account.
“I have some clients who have between 2.5 percent and 3.5 percent mortgage rates; it’s really a difficult argument to make that paying off that mortgage is the very best thing to do since you probably could utilize your money elsewhere and make more,” says Blackwelder.
Either way, paying off your mortgage early shouldn’t even be on your radar if you’re battling high-interest debt or haven’t yet build up your emergency fund. But if you have done those things, and you’ve got some extra cash in your budget, wiping out a hefty mortgage payment might be your idea of financial freedom.