Buying a home is likely 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 paying off your mortgage early 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.
What are the benefits of paying off your mortgage early?
Everyone may have different goals for paying off their mortgage aggressively. However, the most popular reason is to save money. But whether you end up with more cash in your wallet depends on a few different things.
Investing vs. Paying Off Your Mortgage
The first thing to think about is whether you’d be better served by investing that extra cash instead of diverting it towards larger monthly payments. Historically, investments receive a 10% (7%adjustedforinflation) 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.
There are a few things to consider when making this financial decision. 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.
Some people may balk at the thought of paying off their mortgage early because mortgage interest is tax-deductible. There is, however, a common misconception associated with this argument. A mortgage interest tax deduction can only be used if you itemize it instead of taking the standard deduction.
While this may work out for some people, research suggests that only 30% of people actually itemize their taxes. However, 68.5% of Americans use the standard deduction.
Standard Deduction Increase
New tax laws have increased the 2021 standard deduction to $12,550 for individuals and $25,100 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 more expensive house, you don’t qualify for the deduction. This is for any home purchased between December 14, 2017, through 2026.
The change doesn’t impact most people. However, it could have an effect on individuals living in high-cost areas like San Francisco, Chicago, or New York. This could be an added incentive to pay off your mortgage early since tax savings are limited even if they itemize deductions.
Cost of Mortgage Interest and PMI
When considering if you would save money when you pay off your mortgage early, it’s important to consider all the costs associated with your mortgage 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. However, 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.
This helps to understand the mindset of individuals who are determined to pay off their mortgage debt as quickly as possible. Even with low mortgage rates, the large amount of money borrowed and the length of time it takes to repay can result in a lot of money being paid in interest.
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 it 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 down your mortgage early, take a look at your other financial obligations. You should definitely prioritize higher-interest credit card debt and private student loans if you want to save as much as possible on interest.
Most financial experts also agree that you should continue contributing to retirement savings accounts, especially if you receive a company match. There are two sides to the retirement argument, however.
On one hand, having a mortgage-free home during retirement can save you a lot of money on your monthly living expenses. But, on the other hand, a low interest rate paired with a rise in the cost of living could make your fixed monthly payment seem extremely low by the time you retire.
Are you prepared for a financial emergency?
Think about your liquid cash — do you have 6 to 12 months of cash savings on hand? Diverting your savings to your monthly mortgage payments won’t help you much in the event of a financial emergency, like the 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 it 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. So if home prices drop, you may have less equity to take advantage of.
If you’re seriously thinking about paying off your mortgage early, check to ensure that it 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 it off early with one of these methods, it’s called a hard prepay.
Even if you do have a mortgage 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 on 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 deciding on your payoff strategy.
How can I pay off my mortgage early?
There are a few strategies you can use to pay off your mortgage early:
- Make larger monthly payments: One way to pay off your mortgage faster is to simply make larger payments each month. This will reduce the principal balance of your loan and shorten the loan term.
- Make biweekly payments: Instead of making monthly payments, you can make biweekly payments (every other week). This will result in an additional payment each year, which can help you pay off your mortgage faster.
- Refinance to a shorter loan term: If you have a long-term mortgage, such as a 30-year loan, you may be able to refinance to a shorter loan term, such as a 15-year loan. This will result in higher monthly payments, but it will also help you pay off your mortgage faster.
- Make a lump sum payment: If you come into a windfall, such as a bonus or inheritance, you can use it to make a lump sum payment on your mortgage. This will reduce the principal balance of your loan and shorten the loan term.
- Consider a mortgage acceleration program: Some lenders offer mortgage acceleration programs. They allow you to pay off your mortgage faster by using a variety of strategies, such as making extra mortgage payments or refinancing to a shorter loan term.
Paying off your mortgage early can bring a sense of accomplishment and may also be a wise financial choice in several situations. However, before you begin, it’s essential to assess the state of your finances to ensure you are ready for potential future circumstances. You may also want to consult a financial advisor to help you devise a plan.