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By Aly Yale
/ CBS News
It can be tempting to pay off your mortgage early, especially if you have the funds readily available. You can retire debt-free, save on interest and even divert those savings to higher-earning investments.
But there are drawbacks to consider, too, and paying off your mortgage early isn’t the right move for everyone. If you’re looking to free up cash, a mortgage refinance may be a better option.
If you elect to go the payoff, route, however, there are a series of considerations you should first make. Here’s what to think about.
One big benefit to paying off your mortgage is that it frees up a lot of cash. You no longer have hefty monthly payments to make and, instead, can invest those funds in other — possibly higher-earning — investments. In the long run, this could mean more wealth.
Freeing up cash also allows you to pay off debts, which could be costing you a significant amount in interest — particularly if it’s credit card debt. According to the Federal Reserve, average credit card rates are currently above 15%.
If access to cash is the main reason for paying off your mortgage early, however, a refinance may be the smarter path.
Homeownership comes with quite a few tax advantages. One of the biggest is the mortgage interest deduction, which allows you to write off the interest you pay toward your mortgage loan each year — as long as your balance is $750,000 or less.
When you pay off your mortgage, you forgo this valuable deduction, and it could increase your taxable income quite a bit.
A quick note: The mortgage interest deduction is only available if you itemize your returns. For many homeowners, taking the standard deduction (instead of itemizing) is more beneficial. The current standard deduction is $12,950 to $25,900, depending on your tax filing status.
Depending on your balance and how long you have left on your loan, paying it off early could save you significantly on interest costs.
Let’s take a look at an example: Say your original mortgage was a 30-year loan for $300,000 at a 5% rate. When you reach year 20 — with a balance of just under $152,000 — you come into a large inheritance and pay off the remaining loan balance entirely.
If you had gone forward on your original payment schedule, you would have paid nearly $280,000 in total interest. Paying it off 10 years earlier? Your interest costs would be just $238,328 — more than $40,000 less.
Use a mortgage calculator and crunch the numbers to determine exactly how much you would save.
Potential prepayment penalties are another drawback to consider. Some lenders charge fees if you pay off your loan too early, as it eats into their ability to make a profit.
These fees vary, but generally, it’s a small percentage of the outstanding loan balance. These penalties are typically only charged if you’re very early on in your loan term — usually within the first three to five years, according to the Consumer Financial Protection Bureau. Not all mortgage lenders charge prepayment penalties, though, so make sure to check with yours if you’re considering paying off your loan in full.
There are other considerations, too. For one, it might give you peace of mind and reduce financial pressure — particularly if you’re heading into retirement. On the flip side, if you’re using all your funds to pay off the loan, it could deplete your emergency savings. This would put you in a bind should you lose your job or have a sudden change in finances.
If you’re not sure whether paying off your mortgage early is the right choice, consider talking to a financial advisor. They can help you determine the best path forward.
A cash-out refinance — which turns your home equity into cash — might also be an option, depending on your goals.
First published on September 1, 2022 / 10:45 AM
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