Should I Pay Off My Mortgage Early — Or Use the Money Elsewhere?
Living life without a mortgage might sound appealing, but there are also other ways to put your money to good use — so make sure you weigh up your options carefully.
February 16, 2022
Most people dream of paying their mortgage off early — or paying off their mortgage at all. But if you’re lucky enough to have found yourself in this situation, it doesn’t necessarily mean it’s the right choice. You might be wondering: Should I pay off my mortgage immediately, invest or do something else that I’m not aware of?
As with most big decisions there are many factors to consider, and the right choice for one person could be the wrong one for someone else. Let’s run through the benefits and disadvantages of early mortgage payments, along with some alternatives, to help you decide.
What are the benefits of paying off my mortgage?
The main advantage of paying off your mortgage is fairly obvious: It frees up your disposable income, giving you extra money to spend on whatever you want. Clearing your mortgage debt will give you better cash flow and make it easier to cover other monthly expenses, which can also help you to work toward different financial goals like saving for retirement. Not to mention peace of mind.
The earlier you pay off your mortgage, the more you’ll save because mortgage interest compounds over time. If your monthly mortgage payments are about $1,000 per month and your home loan of $200,000 has an APR of 5%, you’ll rack up over $186,000 worth of interest charges over the course of a 30-year mortgage. Paying everything off means you’ll stop accumulating interest and save a great deal of money.
However, this decision isn’t as much of a no-brainer as it might seem at first. Here’s why.
Is there a disadvantage to paying off my mortgage?
Do you know the phrase “there’s no such thing as a free lunch”? We can apply that to the decision of whether to pay off your mortgage.
In the world of economics, there’s a concept called the opportunity cost: The price of missing out on certain opportunities by making a particular decision. In other words, what are you giving up by accepting a free lunch (such as your time), and what are you not using your money for when you decide to pay off your mortgage?
Maybe it means that you’re missing out on investing in the hottest new cryptocurrency or donating it to charity.
We’re not saying that you should use your entire nest egg to invest in bitcoin or make donations — but it’s worth having a serious think about the different ways you could allocate your money. Shortly, we’ll give a few of our top suggestions.
Also, if you’ve already had your mortgage for a while, there won’t be as much to gain by opting for a mortgage payoff. You’ll already have accumulated lots of interest over the years, and later in your term when you have a smaller loan amount, you’ll most likely be using your monthly payments to build up home equity rather than pay off interest.
Also, in some cases, you might be hit with a prepayment penalty, so check this with your mortgage lender.
Comparing interest rates
When deciding between potential uses for your money, comparing interest rates associated with different opportunities is crucial. Don’t get distracted by looking at your interest payments (the amount you pay per month) — what you really need to look at is the APR (the interest rate you pay each year including charges).
In the example we gave above of a mortgage with an APR of 5%, you need to ask yourself if you have any debt with an APR greater than 5%, or if there are any investment opportunities offering greater than a 5% yield. More on this shortly.
However, it’s worth noting that mortgage interest rates may be rising soon after hitting historic lows in 2020. Therefore, paying mortgage loans might look less urgent relative to other opportunities right now, but we have to keep in mind that things won’t necessarily stay that way forever.
To make matters even more complex, the IRS offers a mortgage interest deduction. This means you can deduct the first $750,000 of your mortgage from your tax bill if you itemize deductions — and a reduction in your tax return is certainly appealing if you fall into this category of taxpayers.
Although deductions alone might not be a good enough financial reason not to pay your mortgage off, combined with other factors it’s worth taking into consideration.
What to do instead of paying your mortgage early
Now that we’ve had a look at the basics, let’s get into some more concrete examples of what homeowners might want to consider instead of funding mortgage payments.
Paying off other debt
If you have other types of debt, like credit cards or student loans, you need to evaluate which is the most urgent for you to pay off. To do this, you’ll need to compare the rates for home loans versus other high-interest debt.
For example, if your mortgage has an APR of 5% but you have a credit card with an APR of 20%, you’d be better off clearing the credit card debt first. It might seem like the credit card shouldn’t be a priority if you only carry a balance of a few thousand dollars compared to a much larger home loan, but it’s better to focus on tackling what will compound the most aggressively over time
Even if you’ve paid off your debt, your mortgage isn’t necessarily the best use of your funds. By investing your lump sum instead, there’s a good chance you could make a better rate of return than what you’re accumulating in your mortgage.
Investing is an important part of a retirement plan such as a 401(k). Because as much as we’d all like to own a home, it’s not the only financial goal that matters. What could be more vital than knowing you have the funds to tide you over in your golden years?
The average return from the S&P 500 (one of the most diversified stock market funds) is just about 10.5%. So, if you’re accumulating 5% in interest from your mortgage, you’d end up richer in the long run if you invested your money. However, we should note that there’s no guarantee the S&P 500 will continue to deliver returns of 10.5%, and it’s common for it to dip by more than this in a single year.
If you haven’t invested before, consider discussing your options with a financial planner before jumping in headfirst.
Building an emergency fund
Do you have any money aside that you can use for emergencies that crop up in your life, such as paying for an expensive appliance replacement or covering your expenses for a few months if you lose your job? If not, you might want to use at least a portion of your windfall to build up an emergency fund.
Most experts recommend having enough money in your emergency fund to cover your basic expenses for at least three to six months.
Should I pay off my mortgage early?
And now we return to the original question to summarize everything we’ve surveyed so far. The bottom line is that deciding whether to pay your mortgage off really comes down to your circumstances.
If you’re retired and have no other debt, paying off your mortgage early can make more sense than any other option. The older you are, the more risk is involved in investing, because there’s a shorter timeframe for your investments to correct for market crashes. You also probably won’t be able to take advantage of the interest deduction.
On the other hand, homebuyers who also have other debts with higher interest rates or who are struggling to amass retirement savings are almost certainly better off using their money elsewhere.
As you’ve probably realized by now though, the kind of financial planning that goes into making a decision like this is far from simple. It’s therefore helpful to speak to a financial advisor if you still have doubts.
Financial independence starts here
Some of the concepts we’ve discussed almost sound like an invitation to endlessly overanalyze your financial situation, but realistically you won’t always be able to perfectly predict the outcome of each possible decision. So speak to a professional if you’re struggling, and focus on the key concepts mentioned here (aka, assessing your other debts and financial goals).
As you might have noticed, figuring out how to allocate your mortgage links to many other money-related topics. Realizing that it’s time to get informed? Consider subscribing to our Tally† newsletter for more personal finance advice.
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