Should I Pay Off My Mortgage Early?
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I have heard this question three times in the past month, so I thought it must be on the minds of at least a few more of you. The answer isn't as easy as you might think. There is no denying that it feels great to get any debt paid off early, especially one that could be taking up 20% to 40% of your monthly budget. When a client comes to me wanting to put a little extra money toward getting rid of her mortgage, I am happy to support the effort. But I do ask clients to consider this list of questions. Depending on your answers, you might want to leave the mortgage alone and focus on something else.
1. Do you have a good, fixed-rate mortgage at a low interest rate?
The home buying process is confusing enough that a lot of people walk out of it not sure what sort of mortgage they actually have. If that's you, go check your documents right now. A fixed rate mortgage means that your required monthly payments will stay exactly as they are throughout the life of the loan, and that's great. Any sort of variable rate mortgage, on the other hand, could bring some nasty surprises. Your variable rate mortgage payments will go up if interest rates go up (and they probably will). If that happens just at the moment when you are trying to get costs under control, your mortgage could become a very painful thorn in your side.
By all means, pay off a variable rate mortgage as soon as you can. But if you've got a nice, predictable, fixed-rate mortgage, ask a few more questions...
2. Do you have other debts?
Your mortgage is what we call a "secured loan," meaning that if you don't make your payments, the lender can claim something of value (your home, in this case) to pay off that debt. When lenders write a secured loan, they don't mind charging you a lower interest rate. A car loan is also secured, but let's face it—it's a lot harder to collect value from a used car than a house. And that is why your mortgage is probably the best interest rate you are ever going to get on a loan that isn't from your mother.
This means that your other debts—credit cards and car loans, for instance—are likely to have higher interest rates than whatever you are paying on that mortgage. Mathematically speaking, you want to pay those down first. As you get the loan with the highest interest rate paid off, shift that payment to the next highest and so on. The mortgage will probably be last on this list. [One caveat: student loans are often secured by the federal government and may not follow this pattern, so check your interest rates first!]
3. Do you need to be putting more money away for the long-term?
This one is not always obvious, but think about it—if you are investing money for a child's college tuition or your retirement or anything else that might be more than 10 years out, you are probably planning to get an average return of at least 5% to 8% per year on the money you are investing. If your mortgage is at 3%, then putting the extra $100 a moth toward paying off the mortgage will save you money at a rate of 3%. But if your investment plans go reasonably, you might be giving up 6% or 8% in returns in order to get that 3%.
As you've probably figured by now, the comparison isn't perfect. You are just about guaranteed to save that 3%, whereas investment returns are never, ever guaranteed (no matter how great your investment strategy). But if your targets and strategy are reasonable and you are investing for the long-term, it's a very good bet that your investments will out-perform the savings you got from paying down that mortgage.
4. How much is your tax deduction doing for you?
You probably know that if you live in the home you own you are getting a tax deduction. What fewer people know is that the deduction is actually for the interest you are paying on that mortgage. In fact, in the early years of your mortgage what you are paying is almost entirely interest. To help you visualize that, I found the handy image below from a website called "Financial Tips":
In fact, mortgages work through "amortization," which means that the bank builds in the interest payments in a particular way. Specifically, your payments go mostly toward interest (in yellow) throughout the first years of your loan repayment. As you can see from this chart, the balance of your payments does not shift toward the actual principal (in red) until you are more than half-way through paying off the loans. (By the way, this is why you want to make absolutely sure your lender applies any early or extra payments to principal!)
Alright, so you are only getting the homeowner's tax deduction on that yellow stuff. Why do you care? Because tax planning is a strategy game. Being able to take the mortgage deduction during a period when your income is higher (especially if it is just over the line of one of the tax brackets) can mean a significant tax savings. So, in getting rid of your mortgage payments faster, you might be getting rid of a key part of your tax savings strategy.
So, should I pay off my mortgage early?
After you've gone through list, you might find that paying off your mortgage doesn't make sense from a mathematical point of view. But there is still one more question to ask. The fact is that, just as we perform better on exams when we feel confident, we tend to handle all of our financial decisions better when we feel good about the steps we're taking. As I've said to more than one client recently, if paying off that mortgage means that you feel more "on top of" everything else, that might be reason enough.