Whether you should or shouldn’t pay off a mortgage is an often debated topic, but the answer to the question has become more complicated as The Federal Reserve continues to make changes to monetary policy. The jump in mortgage rates have forced homebuyers to face rates that are near their highest levels since August 2009, when the economy was in the grips of the financial crisis.
While there are psychological benefits of avoiding debt, let’s approach this question from a logical standpoint. Address the following questions, and be sure to consult with a financial professional when making a decision.
What Is Your Mortgage Interest Rate?
The average interest rate in 2020 was 3.10%, and in 2021 it was even lower – an average rate of 2.96%. These rates were historically low, so those that got a mortgage or refinance in 2020 or 2021 may not feel the urge to pay off outstanding debt early because the total interest on the loan is reasonable.
If you have a high mortgage interest rate and can’t refinance, you may be more inclined to pay off your mortgage early. But still, consider the following…
What Other Debt Do You Have?
If you have other high-interest debt – like credit card debt, student loan debt or other loan debt – generally speaking that debt should take priority for early pay off. Mortgage debt has historically been considered one of the safest forms of “good debt,” since your monthly payments eventually build equity in your home.
Do You Have an Emergency Fund?
Paying off a mortgage requires you to deplete cash, or liquidity. If that cash leaves you without an emergency fund, you could find yourself scrambling to fund an unexpected expense down the line. Generally speaking, your home is not considered a liquid asset because should an emergency arise, it could take months (or longer) to sell the property and access the capital, or take cash out of your home equity with a refinance.
Focus first on saving for unexpected events. Most experts believe you should have enough money in your emergency fund to cover at least three to six months’ worth of living expenses, as well as assets that are easy to convert to cash in a pinch, like stocks, mutual funds, U.S. Treasuries, bonds, etc.
Do You Have a Retirement Plan?
If you invest the money you would’ve used to pay off your mortgage into a retirement account, like a 401(k) or IRA, your return over the long-term could exceed the savings of paying down your mortgage.
What is the Opportunity Cost?
Paying off a mortgage early comes with a cost; the money used to pay down the mortgage cannot be used for other opportunities. Loosely speaking, if you could find an investment that offers a rate of return higher than the rate you pay on your mortgage, then you could invest the money that would be used to pay off your mortgage, and still have money left over.
The caveat here is there are tax considerations, because investment earnings are taxable and depending on the earnings, taxable at different rates. There’s also risk involved in every investment opportunity.
Does Your Mortgage Carry a Prepayment Penalty?
You may want to avoid paying your loan off early if your mortgage carries a prepayment penalty, which is a fee a lender can charge for premature pay off.
Prepayment penalties are typically equal to a certain percentage you would have paid in interest, so if you do pay off your principal early, you’ll end up paying the interest anyway. That said, these penalties usually expire a few years into the loan. If you’re unsure whether your mortgage carried a penalty, consult with your mortgage lender or reference your mortgage contract.
- Mortgage interest is tax deductible through the federal mortgage interest rate tax deduction. Paying a mortgage off early reduces the interest expense on the corresponding tax shield, reducing or eliminating eligibility.
- There are alternative investment options, like fixed income, available to investors that are less risky than the stock market that still offer potentially greater average returns than the cost of a mortgage.
Ultimately the decision comes down to personal preference and whether the benefits outweigh the costs. Our team of financial advisors are able to look at your specific situation and provide advice on whether paying your mortgage off early makes sense. If you need additional assistance, schedule a free 1-on-1 call below.
Disclosure: Before making any investment decisions please consult with a financial professional.