Does It Make Sense To Pay Off Your Mortgage Early?
For many people the American dream isn’t just to own a home with a white picket fence, but to own that same home free and clear of a mortgage. While more and more Americans are carrying mortgages into retirement, some have the ability to pay their mortgage off early but wonder if it makes financial sense to do so. Well, wonder no more as in today’s blog I’ll go over why it may or may not make sense to do so.
Before I answer any financial question, I always respond with the words “Well, that depends…” Simply put: no financial matter should be considered in isolation, but instead a person's entire financial picture must be considered. Such considerations would include current savings, investments, retirement plans (pensions, 401ks, 403bs, etc.), financial goals, and present and future tax rates. These factors are especially relevant as to whether one should pay off their mortgage.
Before Paying Off Your Mortgage You Should Consider…
Having an emergency fund (3-6 months of expenses that are liquid). Also, if anyone is financially dependent on you (spouse or kids), I believe you should have term life insurance in place. For more on this please see my previous blogs: Love Insurance and In Case of Emergency.
You should consider having no other consumer debts (student loans, credit cards, auto loans, personal loans, etc.).
Assessing your situation to determine if you are on track for the type of retirement you want, and that you are still able to max it out each year if desired. How do you know if you are on track? That also depends on a number of factors, but first read this blog post which provides a general idea: Will I Be Able to Retire?
If you have accomplished the above and still have money left over each month, congratulations! You are in very rare company. Now we can consider whether it makes sense to use that extra monthly income to pay off your mortgage early.
Here are a few other things to consider:
(1) How long do you plan to live in your home?
If this isn’t your forever home, and you plan on selling in the near future (less than five years), it may not make sense to put money towards the principle that a future buyer would be paying off instead.
If this is your forever home then it is really a choice between several options, namely:
Save the extra cash in the bank. I believe this may not be the best option as with placing your money in a bank account you remove the ability to take some risk and seek potential growth opportunities in the market. With no risk you limit your potential for reward. However, the bank could be your best bet if you plan on making a large purchase in the near future (1-3 years). See my blog called The Silent Thief.
Invest in your children’s college. This could be a great option to consider if you plan to help your child(ren) pay for college and have a high level of risk associated with it. See my blog called The Cost of College & How Best to Pay For It.
Invest in the stock market. This may also be a great option if you plan on investing for the long term (>5 years). However, this has the most risk associated with it. There may be less oversight required for this investment, especially if you outsource these decisions. See my blog called The Best Time to Invest.
Invest in a rental property. This may also be a worthwhile option if you plan on investing for the long term (>5 years), but this has more risk associated with it than many think, and it does require more maintenance than investing in the stock market.
(2) And Finally…
Paying off your mortgage early. This too is a very good option, and I believe it has some of the lowest risk associated with it.
Why Paying off your Mortgage Makes Sense
Paying off your mortgage early provides essentially a risk-free “rate of return”. For example: if your mortgage rate is at 4.0%, by paying it off early you are essentially saving 4.0% because by paying down some of your principle you are not being charged 4.0% on that amount. The stock market offers no such risk-free returns. 4.0% isn’t an incredible rate of return, but considering you aren’t having to pay that in an interest rate on a loan, it’s pretty fantastic. Of course mortgage rates in 2021 are much lower than 4.0%, and so the interest savings would be less.
Investing
Another alternative is to invest the money saved from paying off the mortgage in a non-retirement account. Of course rates of return are not guaranteed in such an account, but we can look at the average returns to gain some sort of idea. Since 1926, the S&P500 (500 largest publicly traded companies in the United States) average annual rate of return through 2018 (including dividends) was 10-11%. Since 1957, (through 2018), it has been closer to 8.0%. But that is the average rate of return. Some years the return could be +31.10% (like 2019), while other years it could be -37.22% (like 2008).*
If you invest for the long term, you could likely be better off investing the extra money each month towards an investment account. Of course, you could split the difference and put extra money towards both. Disclaimer: Investors cannot invest directly into an index and past performance is no guarantee of future results.
Is your mortgage rate fixed or adjustable?
If your mortgage rate is adjustable, you may want to consider paying it off early.
But what about the mortgage interest tax deduction?
Some argue that by paying off your mortgage early you “lose” the tax deduction. People who argue this do not understand interest or taxes because you pay a lot of interest to receive that so-called deduction. Let me provide an example: Let’s say you paid $10,000.00 in interest last year to the bank. That interest paid can then be offset against your earned income. If you were in the 25% tax bracket that means you would pay $2,500.00 less in taxes. Sounds great until you realize that you had to pay $10,000.00 to a bank in interest to save $2,500.00 in taxes. Although that $10,000.00 in interest technically only cost you $7,500.00, it was still a cost to you.
Additionally, the mortgage interest-rate deduction is only used by those who itemize their deductions. With the 2021 standard deductions raised to $12,550.00 for single filers and $25,100.00 for joint filers**, some may not even use the mortgage interest rate deduction to reduce their taxes.
No dollar amount can be assigned to this rationale. While there may be strong arguments to invest the money, there is something powerful about not being beholden to anyone and being completely debt-free. I’ve heard it said that your house feels different after it’s paid for.
So which is better: invest the extra money, or use is to pay off your mortgage?
The truth is that they are both good options. While there may be a strong case to invest, there is risk associated with it. If you are one that is okay with risk, then it could make sense to invest. If you are someone who is uncomfortable with risk, paying off your mortgage could be something to consider.
Conclusion
I hope you enjoyed this week's blog! Please feel free to share your thoughts, or make a suggestion to any topics you think I should highlight in a future blog.
Resources:
*- https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp
** - https://www.kiplinger.com/taxes/tax-deductions/602223/standard-deduction-for-2020-or-2021
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
The hypothetical examples listed above are not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
Investing involves risk including loss of principal. No strategy assures success or protects against loss.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
