Paying Off Your Mortgage Early: Pros and Cons

Paying Off Your Mortgage Early: Pros and Cons

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Borrowers should pay off their mortgage early when they have large amounts of cash, well in excess of what they need for emergencies and retirement contributions, and want to reduce their overall interest expenses. It’s natural to want to pay off your mortgage as quickly as possible, but early repayment only makes sense if it allows you to save money and achieve your long-term financial goals. As with anything, there are benefits and drawbacks to paying off your mortgage early, so make sure it's the best decision for your own situation before you divert funding from your 401(k) or savings account.

Reasons You Should Pay Off Your Mortgage Early

If you want to reduce the overall interest you pay on your mortgage or free up cash for other uses, paying off your mortgage early can help. Every month you have a mortgage, you pay interest on the total balance left. By paying that balance off early, you eliminate years of added interest payments charged for the loan. Depending on how much is left on your mortgage, this could equate to thousands of dollars in savings.

Paying off your mortgage in full also frees up cash flow each month. This reduces financial strain on your household and gives you more resources to invest or save—a move that could net you higher returns in the long run. Having your mortgage paid off can also help in retirement, lowering your monthly household costs and stretching your retirement dollars further.

You don’t even have to pay off your mortgage in full to enjoy benefits. Paying a large lump sum toward your loan balance lowers your overall interest costs and helps build equity. Once you have 20% equity in the property—meaning you have paid off 20% of the total loan—you can cancel your private mortgage insurance (PMI) and lower your monthly costs even further. PMI can cost homeowners between 0.5% and 5% of their original loan balance.

If you've paid off a significant amount of your loan, you have the option of leveraging that equity to secure a home equity line of credit or cash-out refinance. These mortgage options essentially convert your equity into cash, which can then be used for renovation costs, emergencies or even tuition expenses. Although cashing out equity will increase your loan expenses and add another lien on your property, it can be a useful source of emergency funding that's far cheaper than an unsecured personal loan.

Reasons Not to Pay Off Your Mortgage Early

If you’re thinking of using cash reserves or savings to pay off your loan, you should understand that this may increase your risks and may not be the most prudent use of your cash. While paying off your mortgage loan early is usually a good idea, there are situations where it may not be best use of your free cash flow. Though you would still have your home equity to tap into, selling your home and accessing those funds may prove difficult. Your ability to do so will depend on other factors, including the local market, interest rates and supply and demand. These factors are hard to predict and could change by the time you need to sell. Therefore, it’s important to maintain a minimum level of cash to meet emergency expenses.

There are also market concerns to consider. Inflation actually devalues any cash you hold uninvested. Assuming inflation continues to rise, the purchasing power of every dollar you hold in cash erodes over time. However, by making all your payments at once, rather than hoarding it in cash savings, your money—and the house you put it toward owning—could be better protected from inflation and changing market conditions. While this may vary based on your unique real estate market, home values generally appreciate at a rate faster than inflation.

You should also consider potential investment opportunities you may lose out on by paying off your loan early. Every time you make a mortgage payment, you're essentially making a risk-free investment by reducing your risk load and investing at your mortgage's interest rate. By comparison, investing your money into stocks and interest-bearing accounts offers the chance to earn returns beyond your mortgage risk-free rate. Every dollar you put toward your mortgage is a dollar you can’t invest in these higher-yield ventures.

For reference, the average return on the S&P 500 stock market index was just over 9% over the past 90 years, while the average rate on a 30-year conventional mortgage is just over 4.5% as of the date of this writing. While this doesn’t mean you should invest all your money in stocks instead of your mortgage payments. This is another thing to consider if you have extra cash to invest, and can be especially important if you weigh the advantages of investing your funds in a tax-advantaged 40(k) account, as described in the segment below.

Keep in mind that some lenders may also charge a prepayment fee for borrowers who pay off their loans early. Make sure you’re aware of your lender’s prepayment policies and factor those into your savings/loss calculations.

Tax, Credit and Retirement Considerations

Paying off your mortgage in its entirety eliminates any tax deductions on your interest payments you can write off as a borrower. Currently, homeowners are allowed to write off the interest they pay on first mortgage loans up to $1 million. This lowers your taxable income and often increases your refund as a result. Paying off your mortgage altogether would eliminate this tax advantage.

Alternatively, paying your mortgage off early diverts funds that could have been otherwise applied to your tax-free retirement contributions. You could lose out on any interest you could have potentially earned on that account. Pre-tax 401(k) contributions are not taxed until withdrawn for retirement. Putting those same funds toward your mortgage—rather than your retirement efforts—would both reduce the future tax write-offs on your mortgage and cost you the interest that could have been earned with those funds.

Finally, paying off your loan early could also be negative for your credit. Payment history, credit length and variety can all influence your score, and credit companies prefer more loan variety than less, all else held equal. Mortgage loans improve your credit mix and offer you a chance to prove your creditworthiness. Early payoff closes a credit account and may result in a slight drop in your credit score and the loss of future opportunities to improve it.

Savings vs Opportunity Costs

When deciding whether to prepay your mortgage, always evaluate what the best use of your cash is, given your unique circumstances. Borrowers should review their individual credit profiles and potential earnings opportunities—things like interest, PMI, etc.—versus the cost to prepay, including lost tax deductions, exposure to inflation and forgone returns on investments.

It’s important to consider the impact of putting your funds toward early loan pay-off versus other investments, savings and financial endeavors. Determine if this plan is likely to net you more returns in the long run, without impairing your ability to retire comfortably, pay for your child’s college tuition or achieve your long-term financial goals. Consider the future repercussions of paying off your loan early, and factor in the volatility of the housing market. Selling your home and cashing in on your home equity may be more difficult than you think, especially if the market goes south.

Remember, your decision isn’t limited to these two options. Refinancing also offers you the option to shorten your loan term, lower your monthly payment and free up cash you can dedicate towards retirement or other investments. The main goal is to choose the route that will deliver the greatest returns and likelihood of financial success in the long-run according to your unique situation.

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