A common question we are asked as financial planners is whether an individual or family should pay off their mortgage. The answer, as it is with many financial decisions, is it depends. In this article, we will walk through key factors to consider if you are thinking about accelerating your mortgage payments. Our goal is to help you weigh the tradeoffs and decide what is best for your situation.
Starting with Liquidity
If you are considering accelerating your mortgage payments, a great place to start is by ensuring you have adequate liquidity. Make sure that you maintain an emergency fund of approximately 3-6 months of expenses before making extra mortgage payments. If something unexpected arises, like a job change or a health event, having these savings set aside is an important safety net.
Understanding Opportunity Cost
The dollars that you use to pay down your mortgage cannot be spent or invested elsewhere. This opportunity cost is central to deciding if accelerating your mortgage payments is the right fit for you. When considering this tradeoff, your mortgage interest rate is an excellent place to start. If your mortgage rate is significantly lower than the yield on investments like U.S. Treasury bills, then it may make more sense to save or invest this extra cash instead of paying down your mortgage. You may also consider riskier investments like equities, which have higher long-term expected returns but come with greater volatility. Paying down your mortgage provides a known return equal to your interest rate, while the returns for other investments are uncertain.
However, opportunity cost is not only about comparing investment returns, but also about behavior. Many people are excited when they imagine their mortgage payment ending. A helpful question to ask yourself is: “If my mortgage payment is gone, what will I do with the extra cash each month?” If that money is likely to be spent rather than saved or invested, paying off your mortgage early may not improve your long-term financial picture.
Consider Renovations as an Alternative
An alternative option for the extra cash you intended to use for mortgage prepayments is to invest in your home with value-adding renovations and improvements. Not only can this increase the value of your home, but you also get to enjoy the upgrades while living there. The tradeoff is that the value a renovation will add to your home is not certain and may not offset the cost. Be sure to evaluate whether the improvement will both enhance your enjoyment of the home and increase its market value. Finally, some renovations will depreciate more quickly over time and may be more worthwhile if you plan on selling your home sooner.
Interest Savings from Paying Early
Paying down your mortgage will save you interest over time. The interest portion of your payment is based on the current balance of the mortgage. Since mortgages are amortized, early additional payments that reduce this balance can lead to meaningful interest savings over time.
One option that some lenders offer is the ability to make bi-weekly payments rather than monthly payments. While this essentially adds one full extra payment to your mortgage each year, the earlier principal payments can help reduce the interest you pay over the life of your mortgage. If this is something you want to consider, verify that the lender will apply this payment schedule every other week instead of holding the extra payment and applying them monthly.
It is worth noting that if you itemize your taxes, mortgage interest may be tax-deductible, reducing some of the financial benefit of prepayment.
Inflation Working in Your Favor
Another factor to think about is inflation. While inflation increases your cost of living and reduces the real returns of your investments, it can work for you when you have fixed long term debt on appreciating assets. Think of it this way, for fixed rate mortgages, your payment will not change over the duration of the mortgage. But over time, the real “cost” declines as the dollar loses value. In a way, your mortgage can act as a hedge against inflation as your payment becomes less burdensome over time.
Remember Refinancing
One tool available to mortgage borrowers is refinancing, which replaces your current loan with a new one, ideally at a lower interest rate. If rates fall in the future, refinancing could reduce the benefit of prepaying today. That said, refinancing may involve closing costs and can reset your amortization schedule, potentially increasing total interest if the loan term is extended. While no one can predict where interest rates will go, refinancing is an option worth keeping in mind as you evaluate whether to accelerate payments now.
Consider the Non-Financial Benefits
While the numbers may tell you one story, the feeling of being debt free can bring significant peace of mind. The peace that comes with being debt free may outweigh the purely financial tradeoffs. For many, owning a home outright and free of debt is a major milestone. On top of this, eliminating this debt also gives you more margin with your budget. This margin may allow you to take new risks like changing careers, starting your own business, or possibly retiring sooner. When weighing whether paying off your mortgage early is the right choice for you, take some time to consider what being debt free would feel like for you.
So Where Do We Go From Here?
While every financial situation is unique, it is important to understand and weigh the tradeoffs:
- Do you have enough liquidity?
- How does your mortgage rate compare to what you can earn elsewhere?
- Would investing in renovations make more sense, particularly if you might sell your home soon?
- Do you itemize your taxes?
- What would being debt free feel like for you?
- Would a hybrid approach of paying down your mortgage while continuing to save and invest be the right fit?
The good news is that paying down your mortgage early and saving for the future are not mutually exclusive. For many, a blended approach is often the best fit for their long-term financial plan.
If you would like help thinking through whether paying off your mortgage early makes sense for you, we would be happy to help. At Petra, we have seen hundreds of different financial situations over the last half century, and what is right for you will almost certainly be unique. We’d be glad to schedule a no-obligation conversation to talk about this decision in more detail.