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When you own a home, the thought of a mortgage looming over your head for decades can be daunting. So, it’s natural to want to pay off your mortgage as soon as possible. Before you decide to use an inheritance, raise or your savings to pay off your mortgage, it’s important to determine whether it really makes financial sense for you. In some cases, the amount you save when you pay off your mortgage early might not be more than what you would earn if you put those funds to work elsewhere. However, the peace of mind you get could make paying your mortgage early worthwhile.
If you’re considering paying off your mortgage early, first contact your mortgage lender or servicer. Based on the terms of your loan, you could be subject to a prepayment penalty.
Generally, mortgage lenders are prohibited from imposing prepayment penalties on most home loans under the Dodd-Frank Act.
If your mortgage is the exception to the rule, a prepayment penalty can only be assessed in the first three years. It’s capped at 2 percent in years one and two, and 1 percent in year three. So, if your outstanding loan balance in year two is $295,000 and you pay your mortgage off, the lender could charge a prepayment penalty of up to $5,900.
Is it better to pay off your mortgage or invest? Ultimately, it’s a personal decision, but investing could be more sensible.
“Sadly, the math tells us it’s almost always better to invest in other places than in your mortgage,” says Richard Bowen, CPA and owner of Bowen Accounting in Bakersfield, California.
Mortgage rates are lower than they’ve been in recent years, so if paying off your mortgage early leads to a return equal to your interest rate, that return would likely be lackluster compared to the annualized return for the S&P 500 — roughly 10 percent over the last 90 years.
A potentially better use of the funds might be to take the cash you’d use to pay off your mortgage and leverage it into buying a cash flow-positive property like multi-family real estate or single-family homes that have the potential to offer higher long-term returns, Bowen points out.
Any choice poses a risk, however. Even after paying off your mortgage early, real estate prices could plunge, leaving you with a potential loss. Carefully consider which risks you’re willing to take. Ultimately, you might be better off not paying your mortgage off early.
“The thing is, no one can give you a guarantee on an investment,” Bowen cautions. “You can put your money in the stock market and lose it. You can put your money in real estate and it doesn’t perform as well as you expected it to.”
Before taking a large chunk of your wealth and using it to pay off your mortgage early, don’t forget to look at liquidity. Your home is considered a non-liquid asset because it can take months — or longer — to sell the property and access the capital.
“If you start paying down your mortgage too fast, you risk depleting your liquidity,” says Amanda Thomas, CFP, a client advisor at Mission Wealth in Santa Barbara, California. “The kind of liquidity you have is important, too.”
One approach is to have an emergency fund, as well as assets like stocks, mutual funds, U.S. Treasuries, bonds and marketable securities available in a taxable investment account. That way, in addition to having money tied up in tax-advantaged retirement accounts and your home, you still have some liquid cash or other investments that are easy to convert to cash in a pinch.
Bowen suggests maintaining a cushion that protects you for at least six months before you consider using a large portion of your liquidity to retire your mortgage early.
Be realistic about what you’re likely to do with your money if you don’t use it to pay off your mortgage early. After the mortgage is paid off, will you actually use it to get ahead?
It might make sense, for example, to put the money into paying off your mortgage early if you struggle with keeping money in the bank. Your home can be a forced-savings tool, and making extra mortgage payments can save you thousands of dollars in interest over time, plus help you build equity in your home faster.
“The right thing to do is the thing you will do,” Bowen says. “All of this has to do with personal habits. If you’re going to blow through the extra money anyway, then it’s better that you put it into your house than spend it.”
Sometimes it’s less about the bottom line and more about peace of mind. If you own your home free and clear, that can provide benefits that can’t be measured in strictly financial terms. For many, eliminating a monthly mortgage payment ahead of retirement can provide mental relief when considering living on a fixed income.
“Personally, I’m paying down my mortgage,” says Thomas of Mission Wealth. “It feels good to have it paid off before retirement. It might not always make financial sense, but it offers peace of mind and it might allow for better budgeting.”
Another potential advantage is the ability to borrow against the equity in your home. Having a considerable amount of equity can allow you to establish a home equity line of credit (HELOC), providing a source of emergency income, as well as allowing you to make home improvements or make progress toward other financial goals.
Paying off a mortgage early is often a consideration for homeowners looking to retire early or stay in their homes for an extended period of time.
Ultimately, the decision comes down to personal preference and whether the benefits outweigh the costs. Consider any prepayment penalty and the potential tax consequences. Also, conduct an inventory of your finances to determine if it’s more sensible to use the funds elsewhere, like to eliminate high-interest debt.
If paying off your mortgage early is right for you, here are some strategies to do it:
If you’re not sure if you should pay your mortgage off early, consider these other options to maximize your dollars:
When considering whether to pay off your mortgage early, it’s important to figure out what works best for your situation and is most likely to help you reach your short- and long-term financial goals. Sometimes, with financial planning, it’s not a straight assessment of what’s best by the numbers. People want to feel good about where their money is going — no matter what the spreadsheet says.
For some, owing money causes stress, and paying off a mortgage early can bring peace of mind. For people nearing retirement, a paid-off mortgage means they have that much more free cash flow from their fixed income when they stop working.
“My wife likes having money in the bank, whereas I’d rather invest it,” says Bowen. “But if money is a tool, then that money is buying her happiness, so it’s working.”
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