One of the most debated topics in personal finance is whether it makes more sense to pay your mortgage off early or invest extra cash. There are advantages and disadvantages to both options, and at the end of the day, there may not be one solution that is best for every situation. No matter which choice you make, to prepay your mortgage or invest extra money, you need to make a decision and then remain disciplined enough to continue your preferred course of action.
I will give you some advice on why you should or shouldn’t pay off your mortgage, and why you just need to choose what is best for you and your financial situation. So let’s get to it!
Why You Should NOT Pay off Your Mortgage
The conventional wisdom is that you should pay off your mortgage as soon as you are able. In most cases, that makes abundant sense. But not everyone’s situation – or preference – is conventional, so you are not looking into paying off your mortgage, that is OK, and here are some reasons why that is OK!
Your Mortgage is Probably the Lowest Rate Debt You Have
This is never more true than it is right now, since we have record low interest rates. A 30 year fixed rate mortgage represents a unique opportunity to lock-in historically low rates – 3.something or 4.something –for decades.And if you look at interest rates over the past 30 years, you can easily appreciate that we may ever see rates this low again.
This is especially important if you have other types of loans at higher interest rates, especially credit cards and student loans. If you pay off any debt at all, you would be best to pay those off rather than your mortgage, since they typically carry much higher interest rates.
You’ll Pay off The Loan Eventually No Matter What
There’s a silver lining in choosing not to pay off your mortgage early –even if you don’t make any special effort, your mortgage will eventually be paid off anyway.This is because mortgages are set up to be self-amortizing – as you make your monthly payments, the principle is gradually reduced until the loan is completely extinguished at the end of the term.
The point is, even if you accumulate cash, invest in other assets, or pay off non-housing debts, your mortgage will still end up being paid off!
If you decide to invest extra savings in places other than your mortgage, just be sure that you don’t add to your mortgage indebtedness. That means avoiding second mortgages and home equity lines of credit. It also means not taking any additional cash out in the event that you refinance your first mortgage.
Paying off your mortgage early may be good for a lot of people, but not paying it off early can also work for a lot of people. You may be someone who will find that your financial interests be better served by not paying off your mortgage. Carefully consider the alternatives, no matter which way you decide to go.
Disadvantages of Paying Off Mortgage Early
While paying your mortgage off early gives you peace of mind and interest savings, the argument from people who think investing is a better use of extra money is that mortgage interest rates are usually quite low. A portion of your mortgage payments are also tax deductible if you itemize your tax return, which means paying off your mortgage early may not be as advantageous as it seems at first glance.
Advantages of Paying Off Mortgage Early
The primary reason most people pay the mortgage off early is for the peace of mind that comes from knowing the house is completely paid for. Being debt free is one of the most important steps in becoming financially free. Plus if you are paying anything like PMI or Mortgage Life Insurance, then paying your mortgage off early will save you this money each month.
If you are at a point in your life where you looking into real ways to pay off your mortgage early, then I have some great advice on ways to help that won’t be such a big shock to the wallet!
Refinance to a Mortgage with a Shorter Term
With mortgage rates currently in the 4.something range, this can be the simplest way to retire your mortgage early. The idea is to refinance your loan, but reduce the term by at least five or 10 years. By doing so, you can convert a 30-year mortgage to a 25-year loan, or even a 20-year term.
As simple as this method is, there are some caveats to be aware of should you decide to go this route:
- You don’t want to refinance if it will result in an increase in your interest rate of something on the order of one percent or more. There’s a point where a higher rate will offset the benefits of a shorter term.
- You don’t want to add closing costs to the new loan balance – doing so will only increase your monthly payments, and make paying off the loan more difficult.
- The term reduction must be based on the number of years remaining on your mortgage as of today. For example, if you are three years into a 30-year mortgage (meaning you have 27 years remaining on the term), and you want to reduce the term to that of a 20 year loan, you’ll have to refinance the new mortgage as a 17 year loan.
Keep each of these points in mind should you decide to do a term reduction refinance. Also, it’s probably not worth refinancing if you expect that you will be moving out of the house in less than five years.
Set up a Bi-weekly Payment Plan with Your Mortgage Holder
With a biweekly mortgage payment, you will make your house payment every two weeks, rather than once a month. At first glance it doesn’t seem as if that will make much difference. But it actually has the effect of making you pay the equivalent of one extra monthly payment per year. And that difference in the annual payment can chop several years off the remaining term of your loan.
Make One Extra Mortgage Payment Each Year
But there’s an easier way to get the benefit of the biweekly mortgage, without having to refinance your current mortgage into one.You can simply make one extra mortgage payment each year, and that will achieve the same result.
There are different ways that you can make a 13th payment each year, but the least noticeable will simply be to allocate extra money into a dedicated savings account –kind of like an emergency fund, but one set up for the specific purpose of making an extra payment on your mortgage each year.
Apply Cash Windfalls to Your Mortgage Balance
This can be the most effective fast-payment method you can use to pay off your mortgage early. That’s because you don’t have to save up for it, you don’t have to increase your monthly payment, and you don’t have to refinance your mortgage.You simply take any extra money you have and apply toward your mortgage balance.Your regular monthly budget will never be disturbed.
There are probably more opportunities to do this than you are generally aware of. The most obvious is using your income tax refund for this purpose. According to the IRS, the average tax refund is around $3,000. If your refund tends to be in that average range, that will be a more effective way of paying off your mortgage than making extra mortgage payments, or even increasing your monthly payment.
But there is another great benefit of paying your mortgage off early. When you prepay a mortgage, you can save tens of thousands of dollars in interest. Once paid off, you also have extra money each month that you would have sent to your mortgage otherwise. You can then use the mortgage payment to invest.
Advantages of Investing
Because mortgage interest rates are usually comparatively low, it may be better to use extra money toward investments that have a potential for larger returns. When you use the money to pay extra on the mortgage, you give up investment returns that are probably going to be higher than the interest you’re saving by paying the mortgage early. For example, if your mortgage is charging 5% fixed interest over the life of the loan, and you could earn 8 to 10% returns on money invested, obviously the money is better used on investments than paying the mortgage early.
Disadvantages of Investing
There are no guaranteed returns when you invest money. You can only assume the average return, but you might find you expected an 8% return on your investments only to earn 4% – in which case you may have been better off paying your fixed-interest mortgage off early instead of investing.
A Blended Approach May Work
If you have extra money, you can use both approaches. For example, my wife and I round our mortgage payment up to the nearest $100. Our mortgage ends in the twenties, so we send over $70 extra per month toward the principal. We have been doing this for over 4 years now and have cut thousands of dollars off our principal and several years from our repayment schedule. The difference is small enough that we don’t notice it on a monthly basis, and still allows us to max out our IRA contributions, make 401-k contributions, and have a little fun money.
Discipline and Consistency is Key
Regardless of which you choose to do, the issue many people face when deciding to use extra money to invest rather than paying off their mortgage early, or to use your extra money to pay the mortgage off early – is a lack of discipline. If you decide to invest the extra money but don’t stick to the plan, now you’ve wasted money you could have used for paying off the mortgage early – or money you could have used for investing in your future.