Should You Pay Off Your Mortgage Early?

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:

  1. 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.
  2. 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.
  3. 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.

Our Approach

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
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. Money Beagle says:

    As we pay off one debt, we apply the payments toward other debt, so our overall debt payment is the same. In this regard, whatever debt you just pay off, take those payments and apply them toward the mortgage. That’s about as balanced as I can think of.

  2. Mike says:

    My wife and I took a slightly different approach. I took a loan out from my 401k. We used this money to pay off all of our credit debt. We then paid off that loan rather quickly(much lower interest rates). At that point we were debt free with the exception of our home. We then began to use a more balanced approach to everything such as emergency funds, saving accounts and paying off our mortgage early. We have accomplished all of our goals much sooner then anticipated.

  3. JoeTaxpayer says:

    I must admit, I still don’t understand the equation applied when getting financial aid. What I do know is you are better off with no cash saved at all as your paid house is not viewed as the same liquid asset as a cash account targeted for college.
    Glad you mentioned the retirement accounts, too many people miss that sweet company match.

  4. howard says:

    The way I look it is this, if i pay the mortgage, it just simply means that I have invest in the mortgage rate tax free. for example, if the mortgage rate is 5%, than if i pay it off early each month or lump sum, whatever i paid off early would means that I just invest the money for 5% tax free and I lost the deduction of the interest for IRS, however dont forget you would get a standard deduction anyway, so the first 12K or so for the standard deduction , i have to deduct from the interest pay to the bank, the 12K for the interest really has no deduction at all because I could have taken the standard deduction anyway. Most of the time, if you invest in a diversify portfolio you would able to beat the return 5% in today rate for the long term.

  5. Mike says:

    Good post. I am an advocate for paying down the mortgage. I have funded my retirement accounts, and with interest rates so low on savings products, the mortgage is all that’s left. I’m blogging about how to pay down my mortgage by age 30. I’m 26 now. It’s not going to be an easy task, but it’s interesting how you can find so many ways to save, if you look. Of course, the argument is that I could make more in the stock market, but I am in the stock market, and I can’t touch my IRA/401K for decades. Paying off the mortgage will affect my life in the short-term and it will be very freeing! I can see it now…

  6. Tom says:

    We elected to keep the mortgage because the interest rate is very low and there are obvious tax advantages (although that will change in 2-3 years in our situation). We focused on education savings for kids (now done with no debt for us and very little for them) and retirement savings. To me there is “good” debt, “bad” debt, and “ugly” debt. For the most part a mortgage is “good” debt, assuming of course you and your lender were prudent in the purchase/loan, there is good equity in the home, and the interest rate is low and locked. “Bad” debt is on cars, boats, vacations, and other big ticket items which nearly always lose value immediately after purchase and often have higher interest rates. A car may be necessary so the debt isn’t all bad, but did you really need the BMW and the extra debt it created? “Ugly” debt is credit or store cards with high interest rates. Uglier still are debts like payday loans.

    The uglier the debt, the sooner you should pay it off. We’re at a point where we have no bad or ugly debt so we could pay off the mortgage by the time my wife retires in a few years. But, instead we’ve “invested” in the house we plan on staying in during retirement. We’ll be more comfortable living in it and when the time to sell comes, hopefully we’ll recoup most of that investment.

    I like the balanced approach. When I was working full time (retired, work part time now), I’d often split a raise into fourths… 1/4 in my pocket, 1/4 into emergency fund, 1/4 into retirement, and 1/4 paying off a debt faster(worst ones first). When one debt is done, use the freed up cash to pay down the next ugliest debt.

  7. Steve says:

    When my wife and I were pleasantly surprised at the adoption tax credit that resulted in a refund in excess of half our annual income (we adopted two special needs children last year). I was tempted to either throw the whole kit-n-kaboodle into the retirement account, pay down our mortgage to about half of its current principal, or sell our current house and combine the tax refund with the equity in our house to buy a larger house to accommodate our now larger family.

    In the end, we decided to pay cash for a home addition on our current residence, and refinance from our present 30-year fixed to a 15-year fixed at a lower rate with a small cash-out to cover a portion of the add-on.

    We’re still getting a larger home, we’re not incurring any significant debt, and we’re not putting ourselves “upside down” by any means on our second mortgage because even with the cash-out, we are still refinancing an amount well below our original loan amount.

    And of course, we’ll have our home paid off about 10 years sooner than we would have on the 30-year fixed.

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