When it comes to buying a home, most families choose a fifteen or thirty-year mortgage. Since either option requires a lengthy commitment, it's no wonder some families look for ways to own their homes faster.
The good news is, prepaying your mortgage can lead to some pretty substantial interest savings over the long haul. Not only that, but it can help you own your home much faster than you would otherwise. Unfortunately, paying your home off early may come with some downsides you never considered.
Should you pay your mortgage off early? Keep reading to learn the pros and cons of paying your home off early, along with strategies to consider.
Paying Off Your Mortgage Early vs. Investing
While paying off your mortgage early can be a smart way to put your additional funds to use, some financial experts say you'd be better off investing that money instead. A well-diversified portfolio should earn an average return of 7 percent, they say, which could be a better deal if the interest rate on your mortgage is lower than that.
Add in the mortgage interest deduction you get on your taxes and investing could leave you a lot better off. Before you pay your mortgage off early, consider the returns you could be giving up by not investing that money instead. If you bought a house when rates were historically low especially, you may face a substantial opportunity cost if you use your extra funds to prepay your mortgage instead of investing.
Prepaying Your Mortgage Feels Good
While the math may speak against prepaying your mortgage, your heart may have its own ideas. No matter what anyone says, there's something satisfying about paying off debt as quickly as you can.
By prepaying your mortgage, you're taking steps to become debt-free and own your home outright faster. For a lot of people, the allure of owning their own home is enough motivation to pay off their mortgage as quickly as they can.
Some homeowners choose to round up their payment every month, while others try to make an extra payment at the end of the year. Others just pay as much as they can each month. While each strategy has its own merits, any of them can help you become debt-free faster.
Analyzing the Pros and Cons:
Benefits of Prepaying Your Mortgage
In addition to owning your home faster, there are plenty of benefits that come with prepaying your mortgage. Potential perks include:
- Save money on interest payments. If you borrowed $200,000 for your home with a 4.75 percent APR, you'd pay $175,568.08 in interest over the course of thirty years. If you paid enough to whittle your repayment timeline down to fifteen years, you'd pay only $80,019.49 in interest during that time. That's a savings of nearly $95,000!
- Eliminate PMI (private mortgage insurance) faster. If the down payment on your home was less than 20 percent, you may be paying PMI or private mortgage insurance. This insurance product typically adds another 1 percent to the cost of your mortgage each year. To eliminate it, you need to have at least 20 percent equity in your home and pay for a new appraisal to prove it. If you pay extra towards the principal of your loan, you can get to 20 percent equity a lot faster.
- Reduce debt-related stress. While a mortgage is typically considered "good debt," it can still add stress to your life. When you have a mortgage, you must make sure you're earning enough to make your payment each month. Whether your income is stable or not, mortgage payments can cause debt-related stress that only goes away when you pay off your home.
- Lock in your return. If you invest your extra dollars in the stock market, you have the potential to lose money over the short-term or the long-term. By prepaying your mortgage, you lock in a rate of return based on the interest you save.
Drawbacks of Paying Your Mortgage Off Early
We already mentioned how you may get a greater return by investing in the stock market instead of prepaying your mortgage. However, there are other notable drawbacks that come with paying your home off early. Those drawbacks include:
- You'll lose the mortgage interest tax deduction faster. For many people, the mortgage interest tax deduction makes a substantial difference in how much taxes they owe. Unfortunately, the value of this deduction decreases incrementally as you pay down your loan. And once you pay off your mortgage, you lose this deduction altogether.
- You lock up your "extra cash" in an illiquid asset – your home. While prepaying your mortgage can help you save money, it can also lock your extra cash up where you can't reach it. If you ever want to start a business or pay for college, you may wish your cash was readily accessible.
- Some lenders may charge prepayment penalties. The bulk of mortgage lenders allow you to prepay your mortgage without any fees. But since some lenders may charge prepayment penalties, you should always check before making additional monthly payments.
- It's harder to establish a credit history without a mortgage. Many people keep their credit history current by making a monthly mortgage payment. Without a mortgage, it may be difficult to establish a credit history for the long haul.
Striking a Balance
The battle between paying your mortgage early and investing will always exist, but there's no reason to choose one strategy over the other. Many people benefit from both strategies by doing a little of both.
For example, it's commonly said you can knock seven years off your mortgage by making one additional payment each year. If your mortgage payment is $1,200 per month, for example, you would pay an additional $100 per month or $1,200 at the end of the year. With this strategy, you could save money and time on your mortgage but also leave money to invest.
Before you prepay your mortgage, you should also make sure you have an emergency fund with 3-6 months of expenses. If your income decreases, you lose your job, or you face unexpected medical bills, having cash-on-hand will help a lot more than having a slightly lower mortgage balance.
Also, remember that investing is crucial if you ever hope to retire. While a paid-off home is important, you'll need money to eat and live once you stop working. If you hope to have enough cash to retire, you need to make retirement savings and investing a priority early on.
Paying off your mortgage early can help you save on interest payments, but it should only be done once your ducks are in a row. Once you have plenty of cash saved and a realistic retirement plan in place, paying extra towards your mortgage principal can make good financial sense.