Having recently paid off all of our non-mortgage debt, we now confront another financial decision–should we begin to pay off our mortgage early? Admittedly this is a good problem to have. But it does raise an important financial decision. We want to use our money in a way that produces the highest return with the lowest risk. And paying the mortgage off early may or may not help us meet this goal.
So as we make this decision, it’s a good time to examine this issue.
3 Things More Important Than Paying Off a Mortgage Early
Before even thinking about paying off a mortgage early, there are three other financial goals that need to be satisfied:
- Build An Emergency Fund: Having at least six months of expenses saved is a must before paying down a mortgage. In our case, I want a full year’s worth of expenses stashed away in a savings account. The key is not to be cash poor as you pay down your mortgage. Otherwise, you could find yourself borrowing money at a much higher interest rate than your mortgage to handle an emergency.
- Max Out Retirement Accounts: Whether it is a company 401(k), a self-directed IRA, or some other type of account, maxing out retirement savings is a priority over paying down your mortgage early. And retirement savings becomes even more important if your company matches a portion of your contributions.
- Save for a Child’s Education: If you have children and plan to pay for some or all of their college education, this should take a priority over the mortgage, too. Keep in mind that with many 529 plans, you also get tax advantages that you will want to take full advantage of.
Beyond the above three financial goals, it’s worth asking yourself whether you’ll have other needs for substantial cash over the next five to 10 years. For example, will you be paying for a wedding or planning an expensive vacation. If so, you’ll want to cover these cash needs, too, before tackling the mortgage.
Why Interest Rates Alone Cannot Answer the Question
Once you’ve reached the point of paying down your mortgage, you still have to decide whether it’s the best use of your extra cash. As a starting point, comparing the interest rate on your mortgage versus the interest rate you can earn on the money is a good idea. You’ll want to factor in the tax savings on a mortgage if you itemize your deductions. For example, we have a 30-year fixed rate mortgage at 4.875%. Assuming a top tax bracket of 28%, our effective interest rate after taxes is about 3.5% (.04875 x (1-.28)).
The question now, however, is what we compare that interest rate to. If we compare it to current savings account rates, paying off the mortgage is a clear winner. Right now, the best rates on a savings account is just over 1%, and that’s before taxes. The problem with this comparison, however, is that interest rates on savings accounts can, and likely will, rise. In contrast, the interest rate on my mortgage is fixed for 30-years. So I could end up throwing a lot of money at the mortgage now, only to see savings account rates hit 5% or more over the next five years.
Some like to compare mortgage rates to the historical returns of the stock market. If you can assume a long term return of six to eight percent from the stock market, it pays to invest rather than pay off a mortgage at a much lower rate. This approach has some validity, but you do need to recognize that you are comparing two options with very different risk profiles. Paying off a mortgage early has zero investment risk, whereas there is plenty of risk in the stock market, even over longer periods like ten or fifteen years.
In the end, comparing rates between your mortgage and possible investment vehicles is helpful, but not conclusive.
Like most things in life, my wife and I believe in a balanced approach. So rather than taking every extra dime we have to pay off the mortgage early, we are taking a 50/50 approach. We’ve saved 12 months of expenses. We max out our retirement accounts and education accounts. And with whatever we have left over, we will put 50% toward the mortgage and 50% toward investments.
Our approach of course isn’t the only one. Dave Ramsey advises to put everything toward paying down the mortgage. While that may be a perfectly valid approach for some, it’s just to extreme for us.
If you are paying down your mortgage early, let us know how you’ve approached this issue.
Published or updated May 17, 2011.