Buying a home is quite possibly one of the biggest purchases you’ll make in your lifetime. Since most people usually take out a home loan to pay for it, they quickly learn that the interest over a 15 or 30-year mortgage can add up to some serious money.
When you first see the total cost of your home on your closing documents, you might get the urge to pay off your mortgage early to avoid dishing out so much cash to your lender.
But is an early mortgage payoff really the best use of your money?
Let’s walk through the pros and cons to see if it’s a smart financial strategy for you.
Do you save money if you pay off your mortgage early?
While different people may have different goals for paying off their mortgage aggressively, the most popular reason is to save money. But whether or not you end up with more cash in your wallet depends on a few different things.
Investing versus Paying Off Mortgage
The first thing to think about is whether or not you’d be better served by investing that extra cash instead of diverting it towards larger home loan payments. Historically, investments receive a 7% average annual return over the long term.
If you’ve either bought your house recently or refinanced, you’ve likely been able to take advantage of a low interest rate. If so, you may earn more investing over time compared to paying off your mortgage.
Of course, with any financial decision, there are a few caveats to this methodology. First, if you’re generally a risk-averse person, you may not be the type to put your money into such aggressive stocks. Or if you’re close to retirement age, it may be wise to start decreasing your risk, even if you had a stronger risk appetite with your investments in previous years.
When thinking about investments, consider how they would likely perform over the same period of time that remains on your mortgage. While you may not be able to predict a future recession, it’s worth thinking about how much wealth you could build over time.
One reason some people may balk at the thought of paying off their home loan early is that mortgage interest is tax deductible. There is, however, a common misconception associated with this argument. Mortgage interest can only be used as a tax deduction if you choose to itemize instead of taking the standard deduction.
While this may work out for some people, research shows that only 30% of people actually itemize their taxes. 68.5% of Americans use the standard deduction.
New tax laws have increased the 2019 standard deduction to $12,000 for individuals and $24,000 for those married filing jointly. That means the potential is high for even more taxpayers to forego itemizing. Consequently, you may not actually be saving money on your taxes because of mortgage interest.
Recent tax changes have also changed the cap on newly purchased homes that qualify for the mortgage interest deduction. The previous limit was a $1 million home, but that has now decreased to $750,000. If you buy a house that’s more expensive, you don’t qualify for the deduction. This is for any home purchased between December 14, 2017, through 2026.
While this change doesn’t impact most people, it could have a large effect on individuals living in high-cost areas like San Francisco, Chicago, or New York. This could be an added incentive for them to pay off their mortgage early since tax savings are limited even if they itemize deductions.
Cost of Mortgage Interest and PMI
When wondering if you would save money when you pay off your mortgage early, it’s important to consider all of the costs associated with your loan. First, think about how much interest you’ll pay over the course of the loan.
Let’s look at an example
Say you buy a $200,000 house with a 5% down payment. That makes your loan amount $190,000. If you get a fixed interest rate of 4.625% over a 30-year period, you’ll actually end up spending over $351,000 on your house — that’s an extra $161,000.
Again, this gives you an idea of the psychology behind people who are passionate about paying down their mortgage debt as quickly as possible. Even though the interest rate is low, the sheer amount of money you’re borrowing added to the time it takes to repay results in a lot of money paid to your lender.
Plus, if you’re like most people and don’t make a 20% down payment, you’ll also likely be paying private mortgage insurance until you refinance or reach 20% equity in your home. For many people, that can take years, and easily adds an extra $50 to $100 to your monthly mortgage payment, depending on your loan terms.
Is it better to pay off your mortgage early?
Is an early payoff really the right option? As you’re learning, it depends a lot on your attitudes toward both debt and the risk-reward model of investing. But another consideration is your overall financial health.
Before you consider paying off your mortgage early, take a look at your other financial obligations. You should definitely prioritize higher-interest debts like credit cards and private student loans if you want to save as much as possible on interest.
Most financial experts also agree that you should continue to contribute to retirement savings accounts, especially if you receive a company match. There are two sides to the retirement argument, however. On the one side, having a mortgage-free home during retirement can save you a lot of money on your monthly living expenses. On the other hand, a low interest rate paired with a rise in cost of living could make your fixed mortgage payment seem extremely low by the time you retire.
Also, think about your liquid cash — do you have 6 to 12 months of cash savings on hand? That’s another step you could think about accomplishing before starting to pay off your mortgage early. Diverting your savings to your mortgage payments won’t help you much in the event of a financial emergency, like loss of a job or a major medical issue.
There are some liquidity options when you have either a low mortgage or none at all. If you need cash, you have more equity to tap into for a HELOC, home equity loan, or cash-out refinance. Of course, that puts you back in debt but could still be a helpful option to have in your back pocket.
The downside to cash savings is that these financial products can take time to apply for and get funded. Plus, they depend on the value of your home. If home prices drop, you may have less equity to take advantage of.
Is there a penalty for paying off your mortgage early?
If you’re seriously thinking about paying off your mortgage early, check to make sure your home loan doesn’t have a prepayment penalty.
Not all mortgages have this clause, but some might; in fact, the penalty could potentially even apply if you pay off your mortgage by selling your home or refinancing the loan. When you pay off your mortgage early with one of these methods, it’s called a hard prepay.
Even if you do have a prepayment penalty, that doesn’t necessarily mean it applies to extra payments made in small chunks over time. In some cases, there may be an annual cap of how much you can pay off without being penalized.
For example, you may be allowed to pay off up to 20% of your mortgage each year. This is called a soft prepay and can help you avoid paying extra money. Either way, be sure to read the fine print of your mortgage agreement before making a decision about your payoff strategy.
How can you pay your house off early?
Once you decide paying off your house early is a good idea for you, be smart about your strategy. Make sure you designate any extra payments towards the principal. If you don’t, your lender may be able to apply the money towards future interest payments, which defeats the purpose of making those extra payments in the first place.
If you send in a check each month for your mortgage payment, you can send in a second check with a note in the memo line denoting that the payment should go towards the principal only. If you pay online, there may be a special field for extra principal payments. If not, call your lender to figure out the best way to send in your extra mortgage payments.
Paying off your mortgage early can feel great and in many cases, also be a smart financial decision. Just make sure to look at the health of your finances before you get started to make sure you’re prepared for a wide range of future scenarios.