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Should You Pay Off Your Mortgage Early?
If you have a home, you’ve probably wondered if it’s worthwhile to pay your mortgage off early. And if so, you’re not alone. Many homeowners wonder how to pay off their mortgage faster or if paying off their mortgage faster is the smartest way to spend their money.
Consider the math and the potential benefits before you decide.
Should you pay off your mortgage or invest?
When it comes to whether or not to prepay your mortgage, there are certain people who will only harp on the financial implications of this decision. On one side of the equation, you’ve got experts who say you should not prepay your mortgage if you are locked in at a low interest rate. Their reasoning is that you would be better off investing your money in the stock market where a reasonably diversified stock portfolio can expect to earn at least 7% on average over the course of a decade or more.
In other words, you wouldn’t want to pay down a mortgage at 4% APR when you can earn a greater return by investing in stocks and bonds through a brokerage account or bumping up your retirement contributions. Add in the home mortgage interest deduction you can take on your federal taxes and, they say, you would be silly to prepay your mortgage and miss out on those perks.
When it comes to people who see the mortgage prepayment issue in black and white, the question is just about math. After all, why would you prepay a loan at 3% or 4% and lose out on part of a valuable tax deduction when you could invest that money instead and earn considerably more?
But there’s an emotional side to prepaying your mortgage, too
Still, there are plenty of people who ignore the math and forge ahead with their mortgage prepayment plans. My parents fell squarely in that category. Instead of taking the standard 30 years to pay off their mortgage, they paid it off in less than 20 years.
Ask them if they care about the tax deduction they missed out on, and they’ll probably look at you like a crazy person. Why? Because the decision to prepay was never about the math to them; it was about their financial freedom. And math aside, they have never regretted their decision to pay off their home and become entirely debt-free.
And a lot of people agree with that sentiment. For some people, like my parents, it all boils down to the fact that they just don’t like debt. It’s as simple as that.
I am also following in their footsteps. We took out a 15-year mortgage four years ago and I have been working diligently to pay it off ever since. We live in our forever home, after all, but that doesn’t mean I want to pay it off forever. As of this writing, I have one payment to make on my mortgage before we will be entirely debt-free. By the time you read this, I will have reached my goal. Ask me a year from now if I regret it and I guarantee you that I will say “no.”
Still, others prefer a deeper analysis. Whether you’re a math person or someone who just abhors debt, there are other advantages and disadvantages to consider as well.
Analyzing the pros and cons
The first one is the home mortgage interest deduction many people claim to make when they file their taxes. With that in mind, let’s take a look at what the home mortgage interest deduction really means.
The easiest way to figure out your home mortgage interest deduction is to look at your effective tax rate. Say your overall tax rate is 22%, for example. On average, the home mortgage interest deduction reduces your taxes by $22 for every $100 you pay in mortgage interest.
That’s a pretty nice perk, but there’s a caveat. Your home mortgage interest deduction is only valid for the amount you deduct over and above the standard deduction, which is available to taxpayers who don’t itemize their returns. As of 2018, the standard deduction is $24,000 for married couples and $12,000 for individuals. Also, the new tax reform bill passed this year placed a $750,000 cap on the mortgage interest deduction, meaning you can only deduct the interest on home loan amounts below this cap.
So what does that mean? As of 2018, a higher standard deduction means fewer and fewer people will itemize their taxes. And, if you don’t itemize your taxes, your home mortgage interest deduction is worth nothing. And even if you do, it’s only worth what it helps you save over the standard deduction that anyone can take. In many cases, this drastically reduces the value of the home mortgage interest deduction to the point where it’s barely worth considering.
But what about those lost investing returns? When you ask people whether or not they prepay their mortgage and why, you’ll find plenty of skeptics who balk at the idea of carrying long-term debt in favor of investing their extra dollars in the stock market. And when it comes to who is “wrong” or “right,” there are several ways to look at it.
Since the stock market has performed well historically, the math favors those who choose to hold onto low-interest mortgages and invest their extra dollars instead.
However, unlike the stock market, which is not guaranteed, the interest you save by prepaying your mortgage is a “sure thing.” Many people are happy prepaying and banking the extra money they save on interest, even if it’s less than they may have earned by investing their extra dollars instead.
Different ways to pay off your mortgage early
Refinance your mortgage – Most homeowners opt for a 30-year mortgage, but refinancing to a shorter term could mean lower interest rates and cut down on the time it takes to pay off your mortgage. It will also save you money on the total interest you pay on your loan, which is an added bonus.
Recast your mortgage – Refinancing a mortgage comes with closing costs, so some homeowners choose to recast their mortgage instead. Recasting typically only costs a few hundred dollars in lender fees and it allows you to lower your monthly payment by paying a one-time lump sum toward your loan principal. This amount allows your lender to alter your amortization schedule and reset your monthly payments without changing the interest rate or loan terms.
Make an additional mortgage payment or two when possible – Even just one additional payment per year can take years off the time it will take you to pay off your mortgage. A common way to cut down on the time it takes to pay off your loan is by making loan payments bi-weekly instead of monthly, which, in total, equates to making 13 monthly payments instead of 12.
Lower your balance with a lump sum payment – Paying a lump sum toward your principal will lower your overall loan balance. Homeowners who receive an influx of cash through work bonuses, tax refunds, inheritance money, a settlement or other sources may want to reserve those funds for this purpose.
Tips on paying off your mortgage
- Check in with your lender before making a plan for paying off your mortgage. Not every lender allows bi-weekly payments, and some carry prepayment penalties for early principal payments. It’s important to know what you can and can’t do when it comes to paying off your mortgage early.
- Consider which payment options best suit your situation. Refinancing can mean securing a shorter loan term and a lower interest rate, but it also means higher monthly payments and additional closing costs that you’ll have to pony up for. Lump sum principal payments or recasting, on the other hand, might not be feasible for homeowners who don’t have access to a larger sum of cash.
- Be sure to maintain an emergency fund. It can be tempting to direct every extra dollar toward paying down your house payment, but make sure that paying off your mortgage early doesn’t come at the expense of having a rainy day fund. It is recommended to have three to six months’ worth of expenses saved before redirecting money toward additional mortgage payments.
A balanced approach
As someone who loves math but despises debt, I see both sides of the issue. And that’s why my family has taken a balanced approach. My strategy has always involved maxing out our retirement accounts first and foremost and then throwing a few extra hundred dollars at the mortgage every month. Sure, our home is almost paid off, but that’s only because we have invested heavily all along, maxed out our retirement accounts, and met all our other financial goals.
We could have paid our home off faster, but I didn’t want to save less for retirement to do it. So, we have taken an “all of the above” approach and done things on our own time.
At the end of the day, only you can decide how to approach your home mortgage debt. When you hate debt, you want to put it behind you once and for all, and that’s understandable. But it’s also understandable for someone to make their decision based solely on the numbers. After all, it’s hard to argue with math.
So, should you prepay your mortgage? It is, and always has been, up to you. Just make sure any decision you make is an informed one.