Should You Pay Off Your Mortgage Early?

“Should I pay off my mortgage?” As a financial advisor, this is a common question from clients and prospective clients alike. And it’s an important one.

Let me save you time and jump right to the answer: It depends.  

Like many financial questions, the answer should be based on a household’s specific situation.  There is rarely a one-size-fits-all response to money questions. So before you make a decision because you heard an expert say yes or no, pause and evaluate what’s happening under your own roof:

Look at the loan itself.  What interest rate are you paying? What’s the term of the loan? How many years have you been paying on the loan?

Look at your savings.  Do you have an emergency fund? Are you contributing the maximum amounts to your retirement accounts?

Look at other debts you carry.  Do you have other high interest debt like credit card balances or student loans?

Look in the mirror.  Are you comfortable investing in the stock market? How important is being debt-free?

Looking at Your Loan

Regardless of the interest rate, you will save money paying off your mortgage sooner than later. A $400,000, 30 year fixed rate loan with a 4% rate will ultimately cost you more than $287,000 in interest. If you set a goal of paying your loan off in 10 years, you would need to increase your monthly payment from $1,910 per month to $4,050 per month — but you would only pay $86,000 in interest to your lender.  That’s more than $200,000 in savings!  

The flip side of this argument is what’s called your opportunity cost. What if, instead of paying that extra $2,140/month to your mortgage, you invested in a diversified portfolio? Investing this monthly savings for 10 years in a moderate portfolio of stocks and bonds earning 7% could grow to over $370,000. Keep that savings up for all 30 years of your loan and your investment could grow to $2.6 million. There are other layers to add to this simple math (such as taxes), but this gives you an idea of why invest-versus-payoff is a popular argument.

How long you’ve been in your loan can also help your decision. Each monthly payment of a typical fixed rate loan pays a portion to the lender for interest and a portion to pay down the principal. In the early years of your loan more payment goes to interest. By the end of your loan, most payment goes to the principal. So the earlier you start an accelerated payoff strategy, the higher your savings will be.

 *Note: make sure there are no pre-payment penalties on your loan and that your extra payments are designated to pay off principal.

Looking at Other Savings

Before considering whether to pay off your loan you should prioritize savings for emergencies and long-term goals. A recent survey from Bankrate.com found just 18% of Americans say they could live off their savings for 6 months (a typical suggestion for an emergency fund is 3-6 months).  

If you’ve built up a nest egg and are thinking about putting all that hard-earned cash towards your mortgage, keep this emergency fund in mind. This is the argument of liquidity. Your savings and most investments are liquid, meaning you could access the cash quickly when needed. Your house is illiquid. If you move most of your savings to help pay off the house, where would you get the cash to cover unexpected life expenses? Selling a house takes time. Opening a home equity line to borrow cash puts you right back in the loop of borrowing cash and paying interest.

A similar argument can be made about long-term savings goals. Paying off your mortgage should come after you’ve dedicated a portion of your income to saving for retirement. Making maximum contributions to a 401k, taking full advantage of an employer’s matching contributions policy, maximizing other retirement accounts when self-employed — all of these considerations should come first.

Looking at Other Debts

Average mortgage interest rates have been in the 3.5% – 5% range for the last 10 years. The average credit card interest rate is about 20%. If you’re carrying credit card balances, paying off this debt should take priority over putting more money toward your mortgage. Sadly, the same argument can be made for many student loans.

In addition, mortgage interest is tax deductible if you take itemized deductions when filing your return. That’s not the case with credit card debt. (*Note: one result of the Tax Reform Bill of 2018 – when the standard deduction was increased to $24,000 for a married couple – was a decrease in taxpayers taking itemized deductions).

Looking in the Mirror

So far, arguments for and against paying off your mortgage have focused on the numbers, so let’s focus on you. The more I work with clients from all walks of life, the more I appreciate people’s different feelings about money and debt. It’s important to look beyond the numbers.  

How does carrying debt make you feel? For some, the peace of mind of not carrying debt — even after hearing how much more money they could save with an investment strategy — is simply more important. It’s hard to put a price on peace of mind. But it should not be discounted.

Also ask yourself: if you didn’t put extra money toward paying off your mortgage, would you really save it or would it just be an excuse to spend more? If your answer is more spending, then a strategy to pay off your mortgage makes more sense. The money not used toward the mortgage should be used in getting you ahead some other way.  

Are you comfortable investing? The loudest argument for not paying off a mortgage is the assumption you’ll invest that money in a diversified portfolio instead. But markets do go up and down. If you’re the type of investor who sells at the first downturn, then this might not be the right strategy for you even when the dollars make sense.  Paying off your mortgage is said to be a “risk-free” return of 4% (using our initial loan example). But to play devil’s advocate, owning property is not risk free either.    

Within a few years of their retirement goal, a high percentage of my clients revisit the mortgage payoff question with me. We discuss the peace of mind of losing a large monthly expense while entering a more fixed income phase of life. But we also discuss how it would feel to see a large chunk of savings depleted right when a whole new spending and life experience begins. Often we land on a compromise: paying a little more to accelerate the mortgage payoff, while giving retired life and the expenses that come with it a little time to see how life changes.

It Depends

And that brings us back to the answer for this burning mortgage question. It really depends.  The middle ground often makes the best plan — paying extra to your mortgage while being disciplined with smart savings for short- and long- term needs. This can especially be the case when first starting out. Going back to our loan example:  a $400,000, 4% fixed rate, 30 year loan would cost $1,910/month and $287,500 in interest. Even if you simply rounded up and paid $2,000/month, you could cut 2 1/2 years off the loan and save $27,000 in interest (making sure that extra payment goes strictly to principal).

To be sure the answer to this popular question is suitable for you, stop and look around. Take inventory and ask yourself what type of spender/saver are you? Don’t discount the non-financial aspects of this decision, but really think about those numbers as well.

And if you need a second set of eyes to review what you see, consider enlisting the help of a fee-only financial advisor.

 


 

Disclosure: Abacus is an SEC Registered Investment Adviser. Information presented is for educational purposes only and should not be construed as investment advice as the information may not be suitable for all investors. The information does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Abacus does not provide legal or tax advice. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

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