In recent years, owning a mortgage-free home has become a trend. According to data from the National Association of Home Builders (NAHB) in the United States, nearly 40% of homeowners fully own their homes, marking a new high in the past 13 years. Among them, two-thirds of mortgage-free homeowners belong to the baby boomer generation aged 60 and above.
However, is paying off a mortgage early truly a wise decision? For many people, it may bring a sense of psychological security, but living mortgage-free may also have some financial implications. Understanding the pros and cons can help you make the right decision based on your own circumstances.
Most lending institutions allow for early payoff of mortgages, known as “prepayment.” This type of mortgage typically does not have prepayment penalties.
However, some mortgages do indeed impose prepayment penalties. If you are unsure, you can check the first page of your loan settlement document or look for an explanation in the section of the mortgage contract named “Right to Prepay.” If still uncertain, contact your mortgage servicer.
Paying off a mortgage early has several benefits. The most obvious one is reducing your basic expenses. If your mortgage takes up a large portion of your monthly income, and your income is fixed, eliminating this expense will give you more disposable income.
You will save on interest expenses. Depending on the loan amount, interest rate, and term, the savings could amount to thousands of dollars.
Another benefit is that if your mortgage interest rate is higher than a risk-free rate of return, paying off the mortgage early is equivalent to earning a risk-free return equal to that rate.
For many people, the sense of psychological security is one of the key benefits of paying off a mortgage early. It is often an emotional goal for many.
However, for those with lower mortgage interest rates, there may be several drawbacks to paying off the mortgage early.
One drawback is that if you need to boost retirement savings, it may be more beneficial to increase contributions to a 401(k) plan or other retirement accounts instead of using a significant portion of savings or income to pay off the mortgage. These savings are taxed only upon withdrawal.
If you have high-interest debts like credit card debt while the mortgage rate is low, paying off the mortgage early might not be the best decision. It is better to first clear high-interest debts, keeping low-interest “good debts” like mortgages as they are tied to assets.
If you itemize deductions, paying off the mortgage means you will no longer be able to deduct mortgage interest from your income on federal tax returns.
Moreover, there is an issue of opportunity cost. If you use all your savings to pay off the mortgage, you might miss out on investment opportunities with higher returns than the mortgage rate.
For instance, financial and investment advisory company Motley Fool states that the average annual return of the S&P 500 index over the past decade is 12.2%, while current mortgage rates are still lower than this level.
If you use savings to pay off the mortgage, your liquid funds will decrease, reducing available funds. Furthermore, this could temporarily lower your credit score as it diminishes the average account age and alters your credit mix.
If you have decided to pay off your mortgage early, there are various ways to do so, and the suitability of each option depends on your situation.
Making an additional payment at year-end and applying it directly to the principal can help you pay off the mortgage early without causing significant financial strain.
This method comes with a substantial impact, but if your mortgage interest rate is high, it could be a good choice. However, you must ensure you have enough cash to carry out this operation without depleting all funds in your savings account.
Making extra payments bi-weekly in a planned manner, deducted directly from your paycheck, can be an option. Unfortunately, not all lenders allow this. Yet, if your lender permits it, this method is a way to pay off the loan early without financial stress.
In the current environment, this method may not be suitable for most people, but if your mortgage rate is higher than the current market rates, refinancing could be considered. Opting for a 15-year loan term can help in early mortgage payoff.
Schwab recommends paying down the principal gradually instead of a lump-sum payment to shorten the loan term.
This approach can reduce interest payments while maintaining asset diversification and liquidity.
In conclusion, the decision to pay off a mortgage early has its advantages and disadvantages, and it is essential to weigh the factors carefully before making a choice. Each individual’s financial situation and goals will determine the most suitable path forward.