I think at some point everyone has thought to themselves should I pay off my mortgage early or do something else with my money?
We’re told all the time by the media that sending in a few extra bucks every month with our mortgage payment will help erase thousands of dollars in interest payments – and that’s a good thing!
But at what cost? What if you could be doing something else with those “few extra bucks”? Perhaps that something else you could be doing may even lead to a better rate of return …
Asking the Question of Should I Pay Off My Mortgage Early:
Where this is all coming from is when my wife and I recently got the itch to check into the possibility of moving into a new house. Moving can be exciting! Basically our decision came down to this:
- A) Move and take on a higher mortgage payment than we have now? or
- B) Stay in our current house, keep paying our current mortgage, and possibly accelerate the payment schedule by sending in the extra cash we would have used for the new house?
Because the two of us are committed to our plan to reach financial freedom early, we ultimately decided to stay in our current house (for now). But then that begs the question:
Should we then stick to our plan to pay off the mortgage early?
Crunching the numbers, I calculate we’d have to send in an extra $500 per month to have our house completely paid off by the time we plan to retire (11 years from now).
I don’t know about you, but $6,000 per year ($500 per month) is a lot of money! While paying off that debt would be a great accomplishment, it sure seems like there are a ton of different things I could be doing with that money. Could any of them potentially be better?
With that said, here are my thoughts to both sides of the argument for why we should or should not pay our mortgage off early.
Why You Should Pay Your Mortgage Off Early:
You don’t need me to tell you that there are plenty of good reasons for paying off your mortgage early and why people rave about why you should.
1. Finally being debt free!
Doesn’t it just feel good to get rid of that mortgage payment? The simple fact of knowing that you’re finally done and don’t have to send in any more money to the bank is one of the most powerful psychological reasons why people do it.
2. Saving yourself thousands of dollars in interest.
A mortgage is a loan. And loans have interest. Therefore the longer you have your mortgage, the more interest you’ll end up paying to the bank over time.
Who wants to do that? Why not keep more of your money instead of giving it away every month.
I highly encourage you to go to a calculator and see just how much interest you end up paying on your house over the life of your mortgage. It is extremely eye opening!
3. Locking into a fixed return rate.
Consider this: When you pay down your mortgage early, it’s the equivalent of investing that money and getting the same rate of return. What does that mean for you? Say your mortgage interest rate is 5%. Then for every dollar you use to pay your mortgage off early, it’s like getting a 5% return.
For an in-depth explanation of how that works, read my post Which is Better – Paying Off Your Mortgage or Investing the Money?
All in all, that’s necessarily not a bad way to get a guaranteed rate of return for your money. Think of the last time a CD at the bank offered you 5%? Depending on how you like to invest your money, you might have to take on substantial risk to get that same return.
4. Reducing the amount of money you’ll need later or during retirement.
A big part of retirement is minimizing how much you need as far as cash flow. So if there was no more mortgage payment, then you’d need a whole lot less during retirement.
For example, let’s say you have a $1,000 mortgage payment and $4,000 in expenses. In the classic calculation, you’d need $5,000 x 12 months = $60,000 per year which equates to a retirement savings target of $1,500,000. But if your mortgage was paid and all you had was the $4,000 in expenses, then you’d only need $48,000 per year which equates to a target nest egg of $1,200,000 instead.
5. Lower taxable retirement income.
Along the same lines as No. 4, if you’re smart about how much taxes you’d like to pay when you’re retired, then you’ll want to make sure you pay off your mortgage before you enter into retirement.
The reason is this: When you retire, you’ll want to withdraw as little money as possible from your nest egg and Social Security so that you pay little to no taxes.
Suppose for retirement you decide you’ll need $30,000 per year pre-tax. Now let’s say that $10,000 of that $30K are your mortgage payments. If your mortgage was paid off, wouldn’t it be better to only need $20K instead of $30K. At $20,000, you’d actually owe no Federal taxes whereas at $30,000 you’d owe something.
Of course there are many ways to dance around paying taxes altogether during retirement, and this could be a complete non-issue. If you’re interested in knowing more about this, check out my how to have a tax free retirement. We actually worked out a scenario where you could withdraw $132,500 from your nest egg without paying any taxes at all!
6. Lowering your risk and protecting your best asset.
If you did pay off your house in full, then you’d never really have to risk losing it! Usually when someone faces a job loss or something like that, it causes them a great deal of stress because they worry about falling behind on their mortgage. But if you own your house outright, then you’d be worry-free.
Why You Should Not Pay Off Your Mortgage Early:
While each of the above reasons above were pretty good, the reasons NOT to pay down your mortgage ahead of schedule can also be just as equally enticing.
1. Heging inflation.
If you have a fixed rate mortgage, then your principal and interest payments will be the same for the next 15 or 30 years (depending on whatever kind of mortgage you took out).
While that may not sound very special, it actually has a very unique benefit to you in terms of inflation protection.
Consider this: As time goes on, all your other monthly payments will go up like your food, gas, utilities, car payments, insurance costs, etc, will go up.
But not your mortgage. Your mortgage is frozen in time. And relative to everything else you’re buying, that payment will actually “feel” like less the longer time carries on.
For example, let’s say you’re paying $800 today for principal and interest. For as long as you have the loan and do not refinance, you’ll always pay $800 every month. So if inflation increases by an average of 3% every year, that $800 will “feel” like the following over time:
Your future self might appreciate this!
2. Find a Better Rate of Return
Above we said that making a mortgage payment is basically the same thing as getting an investment with the same return rate. So let’s suppose that you refinanced your mortgage within the last year and got a fixed rate at 4.0%. If the average annualized return of the stock market (such as the S&P 500 index) is 8.0%, then that’s a difference of 8.0% – 4.0% = 4.0%. If you’re investing for the long haul, then rather than paying off your mortgage early, why not go for the market average and shoot for an 8% return instead of a 4% one?
3. Inability to tap into the funds due to loss of equity
What if we have another Great Recession like we had in 2008 and house values don’t go back to where they once were? What if they drop even further?
While debt is debt and you’ll have to pay off your mortgage no matter what your house value is, it may not strategically make sense to “park” your money in your house by paying your mortgage off early.
Consider if you made extra payments towards your house and you suddenly had to move for some reason. What if your house unfortunately sold for less than what you still owe on it? You’d never recover all that money you paid into your mortgage, and so you’d be out. According to this story from ABC News, this is unfortunately exactly the kind of thing that happened to one couple when they decided to use their 401k retirement funds to pay off their mortgage rather than waiting.
A better place may be to temporarily park your extra cash in an emergency fund or someplace where you can have access to it in case something came up.
4. Low interest rates.
When I refinanced my house two years ago, I thought I’d never see interest rates that low ever again. Imagine my surprise when rates continued to fluctuate and banks were offering 15 year loans as low as 2.75%. Could you imagine a mortgage with a rate as low as 2.75%? That’s less than the average 3% inflation rate.
If you were lucky enough to lock into one of these ultra low rates, then you’re basically paying a historical low of almost next to nothing for your mortgage.
5. Fewer income tax return breaks.
You may not realize it, but your mortgage interest is deductible against your U.S. income taxes. Most other forms of debt (like a credit card or car payment) are not. While there is always a Standard Deduction, in some situations it may work out better for your tax situation to have more interest to declare.
Unfortunately this point can be somewhat weak in the pay off your mortgage early debate. Suppose you own a median priced house with around 20% equity in the house. In that instance the IRS Standard Deduction would automatically exceed whatever tax benefit you’d receive from itemizing.
6.Taking Care of Other financial goals.
Foregoing putting money into your 401k?
Not stuffing your emergency fund with the cash it needs?
Do you have high interest debt you should be paying off instead?
Maybe relative to these things paying off your house early just isn’t a huge priority.
Perhaps you’d rather dream big by starting a business, buying real estate, or fund other investment goals (like buying more dividend stocks) instead.
What is the Right Answer?
So after all of that, you’re probably wondering to yourself which of these directions is the right one to go in.
The short answer – it depends entirely on you.
Only you know your own financial well being. Perhaps some of the points we made here carry more weight to you than others. Regardless, there is never really a good one-size-fits-all answer to these kinds of situations. All you can do is look at the possibilities and decide for yourself which ones fit your position the best.
Readers – What do you think? Have you ever given much thought to the question of should I pay off my mortgage early? Did you end up doing it? Or did you find other reasons why you should do something else with the money?
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