Should you pay your mortgage off early?
If you’re a homeowner and are fortunate enough to have accomplished the first several steps on the road to financial security — you’ve saved an emergency fund, paid off high-interest debt and are saving for retirement — you’ll likely begin to fantasize about living mortgage-free. You could be done paying interest, done with big monthly payments and own your home free and clear.
If you’ve given any serious thought to paying off your mortgage early, you’ve likely come across two competing opinions on the matter:
- Yes! There’s no such thing as “good debt.” Pay off your mortgage as soon as you can, get a guaranteed return on your money equal to your mortgage interest rate. It’s the only sensible thing to do.
- No! With mortgage rates so low, you should be investing any extra money at a higher interest rate. Plus, mortgage interest is tax deductible, providing an additional incentive.
- Another option! Going for a mortgage refinance to open up another sum of money at a competitively low interest rate. If you’re intrigued by the mortgage refi route, start here.
Yes! Pay off your mortgage early
Stocks are a risk, but your mortgage payment will always be due.
The biggest argument against paying off your mortgage early is that you could get a much higher rate of return by investing. The S&P 500 has yielded an average annual return of about 10% for the past 88 years.
But those returns have also been wildly inconsistent. For example, since 2000 there have been two major reversals in the stock market, and we might be going through another one right now.
How would it be for you if you accumulated $100,000 in your stock portfolio over the past 10 years – instead of paying off your mortgage early – only to see an ugly bear market wipe out 50% of your portfolio?
One of the inherent problems with investing in risky assets is that the returns are neither consistent nor guaranteed. However, when you owe money on a debt, especially a very large one like a mortgage, your liability is fixed. That is to say that even if your stock portfolio takes a big hit, your mortgage will be a fixed obligation. That includes both the balance owed and the monthly payment.
Few people regret paying off debt.
There are huge psychological benefits to a debt-free life.
Even with a relatively low interest rate on your mortgage (let’s say 4%), paying it off provides a guaranteed return, plus the elimination of your monthly mortgage payment. No matter what the historic track record of the stock market is, there is no guarantee that your portfolio will perform at that level over the next 10 or 20 years. How much better would you sleep with no mortgage payment?
As much as we might think of financial decisions as being a numbers game, they do come with the potential for both psychological and emotional problems. If you don’t think that you could stomach losing a bunch of money on your stock portfolio while you still owe a fortune on your house, you’re almost certainly better off focusing on paying off your mortgage.
If being debt free is more important to you than having a large investment portfolio, concentrating your efforts on paying off your mortgage is the better course.
No! Paying your mortgage early is silly
We already know that the common argument against paying off your mortgage early is to earn larger returns in the stock market. The historic return on stocks invested in the S&P 500 has been on the order of 10% per year going all the way back to 1928. It doesn’t make sense to pay off a mortgage that has a 4% interest rate, and give up likely returns on equity investments of 10%.
It could be argued that once your mortgage is paid off, you’ll have more money to invest in stocks. But even if you’re able to reduce a 30 year mortgage to 15 years, you will still have lost 15 years of compound investment earnings. That’ll be close to impossible to make up.
But this is risky, and there’s nothing wrong with forgoing larger (but riskier) returns for a guaranteed return and peace of mind. But there are other, perhaps more compelling, arguments against paying down a mortgage early.
Your home will be a disproportionate percentage of your net worth.
By paying off your mortgage early, it’s likely that a large amount of your net worth will be tied up in your home. This comes with its own risks. Real estate is often considered a safer investment than stocks, but it’s not without risks. If you need to sell your home during a soft real estate market, you may lose money or — worse — be unable to liquidate at all.
Similarly, consider what would happen if a life event required you to come up with a lot of cash — more than you have in emergency savings. Imagine you become unemployed for many years, need extensive medical care, or decide to invest in a business. Stocks can be easily sold to finance such needs, but if your net worth is tied up in your home, you would either have to sell your home or rely on a home equity loan (going back into debt). If you don’t mind the idea of tapping home equity, then this argument is less persuasive. And indeed, if you do pay off your home early, taking out a home equity line of credit (just in case) can be a good idea, even if you never plan to use it.
You won’t realize the benefits of extra mortgage payments for many years.
With the exception of swashbuckling business people who use massive loans as leverage to acquire millions, most of us want to become debt free. But not everyone has a willingness to make it happen. There’s no ignoring the fact that paying off a massive debt like a mortgage will require a whole lot of sacrifice. Are you willing to pay that price?
As an example, let’s say that you have a $250,000 30-year mortgage at 4.25% that you want to pay off in 15 years. Your current principal and interest on the loan is $1,230 per month. In order to pay it off in 15 years, you’ll have to increase the monthly payment to $1,881. That’s an increase of $651 per month, or $7,812 per year.
Coming up with that extra money every year will be a huge commitment. It’s certainly possible, but you’ll have to understand the sacrifices required to get there.
- If you have a fixed-rate loan, you won’t realize any benefit until the loan is actually paid in full. (Your payment will not go down as you pay down the mortgage balance.)
- If you abandon the early payoff effort before you complete it, you will have even more money tied up in your home than you have now; this is sometimes referred to as dead equity since it has no return, and produces no immediate benefit.
- As we mentioned above, if you need money from the equity in your home — because that’s where all of your extra cash has gone over the past few years — you will have to borrow the money out with a second mortgage or home equity line, which will reverse all of the good that was done with the early payoff effort.
Since it will likely take at least 10 or 15 years to pay off a mortgage early, it’s best if you have a large emergency fund so that you are not repaying your mortgage with money that you can’t afford to lose. Unlike paying off other debts, like credit cards or car loans, a mortgage loan is a long-term project, and you need to be ready for contingencies.
If you lose your job, you could be screwed.
Let’s drive home again the point that your home is not a liquid asset. There are only two ways to get cash out of the home:
- Borrow against it
- Sell it
We just discussed how borrowing money against your home will virtually defeat the purpose of paying it off early. But there is an additional complication if you lose your job: it’s unlikely that you will be able to obtain a loan against your home if you’re unemployed.
During a period of prolonged unemployment, your only choice may be to sell your house in the event that cash is especially tight.
Once again, a plan to pay off your mortgage early should come with a companion commitment to building up a large emergency fund that will see you through a time of prolonged unemployment.
Mortgage interest is tax-deductible.
For most people, home mortgage interest is the single largest income tax deduction they have. It’s even possible that paying off your mortgage will make it impossible for you to itemize deductions on your tax return.
This points to another tax related consideration: If your current mortgage rate is 4.25% , but you have a combined federal and state marginal tax rate of 40% , the effective rate on your mortgage is only 2.55% (4.25% x .60).
Realizing that your effective rate is that low could make you more willing to entertain the risks of pursuing higher returns in the stock market.
Refinancing is worth considering
If you’re considering paying off your mortgage early, you may have some equity built up. That makes you a great candidate for a refinance. You may be able to get a lower interest rate and/or reduce your monthly payments to free up some extra money. You can then put that excess aside or invest it.
It’s never been easier to refinance your loan, thanks to tools like Credible. Credible shops lenders and provides multiple quotes for your refinance without affecting your credit score. You can review those quotes and decide if refinancing is the best option for you.
Credible also lets you do a cash-out refinance, which is something to consider if you’re thinking about paying your mortgage off early. With a cash-out refinance, you can take some of your home’s equity as a loan. In some cases, your monthly mortgage payment won’t change and you’ll have some extra funds to save, renovate your house, pay off debt, or whatever else you need.
Paying a mortgage off does not come without risks. There is the risk of opportunity cost – that the return on an equal amount of money invested in stocks could be more beneficial than paying off your mortgage early. There is also the risk that you could face a prolonged career crisis that a large home equity position won’t help.
What are your thoughts on paying off your mortgage early? Do you think the benefits outweigh the risks?
- Will I save money by refinancing my home?
- What rate of return should I use for planning for retirement?