The question presents two key challenges. First, for most the mortgage is just one of many financial goals. In some cases prioritizing these goals is easy. One should tackle a credit card bill charging 20% interest before a fixed rate mortgage at 4%. In other cases, however, prioritizing competing goals can be more challenging. For example, do you save for a child’s education before putting any extra money on the mortgage?
Second, a mortgage can present a number of emotional issues. We feel secure at the thought of owning our home. Ironically, paying off a mortgage can actually make us less financially secure if doing so requires us to use up all of our available cash.
To sort through these issues, this article and podcast look at when we should and when we should not pay off our mortgage early.
The analysis makes an important assumption. Specifically, this article assumes that we are dealing with a low, fixed rate mortgage. Adjustable and high rate mortgages should generally be refinanced to low fixed rate mortgages if at all possible unless one is planning to move soon.
Why You Should Not Pay Off Your Mortgage Early
1. You still have other debt
In almost every case, the mortgage should be the last debt you pay off. If you still have other debt, including second mortgages and home equity lines of credit, these should be tackled first. Typical debts include the following:
- Car Loans: Most car loans come with interest rates higher than mortgages at current rates. Interest on a car loan is also not tax deductible.
- School Loans: Particularly for those who have refinanced their school loans or taken advantage of certain repayment plans, there may be no advantage to paying off the loan early. But even with refinanced loans, rates are typically higher than a mortgage and the term of the loan shorter. As a result, it’s almost always better to pay off school loans before turning to the mortgage.
- Home Equity Lines of Credit: While second mortgages may be tax deductible, the interest rates are higher than the mortgage.
- Credit Card Debt: It should go without saying that paying off credit card debt is a high priority. Even if you take advantage of 0% balance transfer offers, these introductory rates only last about 18 months.
As noted above, many debts can carry 0% interest, at least for a time. In almost all cases, however, these 0% deals are either temporary or apply to relatively short term loans. As a result, paying these loans off is almost always a higher priority than the mortgage.
2. You don’t have a 12-month emergency fund
As a rule, one should have at least enough money in taxable accounts to cover expenses for a year before applying extra money to the mortgage. While you are paying off debt and working to maximize retirement accounts, a 12-month emergency fund is likely too rich. But when these goals are met and the decision is to pay off the mortgage early, 12 months is a sound goal.
Liquidity should always be an important consideration. Paying off the mortgage early requires a lot of cash. While it may be a reasonable plan, one shouldn’t pay off the mortgage in a way that eats up all of your cash.
3. You aren’t saving 20% of gross income (at least)
We shouldn’t divert money to the mortgage until we are saving a significant portion of our income. At an absolute minimum, we should be saving 20% of our gross income before applying extra cash to the mortgage. These savings will likely include both retirement savings to 401k and IRA accounts, as well as savings to taxable accounts.
4. You are still saving for big purchases
It’s not enough to pay off debt and save before tackling the mortgage. It’s also important to make sure you have future cash needs addressed. Generally, you should plan to cover significant purchases for at least the next five years, and 10 years would be preferable. Typical big purchases might include the following:
- Child’s Education (529 Plan)
- Car Purchase
- Home Remodeling
There’s no point in paying off the mortgage only to go into more debt for a large purchase.
5. You are investing the extra cash in a smart way
Once we’ve paid off all debt, have a solid emergency fund, are saving at least 20% of our income, and have our cash needs met for five to 10 years, using the extra cash to pay toward the mortgage is a reasonable choice. Nevertheless, it’s here where a big debate arises–is it better to pay off the mortgage or invest?
Dave Ramsey argues we should pay off our mortgage. It’s Baby Step #6 on his path to financial freedom. In contrast, Ric Edelman argues that we should never pay off our mortgage. Why? Among other reasons, Edelman argues that “[m]ortgages, in fact, are the cheapest money you will ever be able to borrow. (Oh, sure, you can get a credit card that offers 0% interest for six months, but try to borrow a couple hundred thousand for 30 years that way.)”
Both views have merit. However, those who invest in a well diversified, equity oriented, low-cost portfolio of index funds will surely outperform the rate on a typical mortgage over the long term. There are some key assumptions here, however.
First, we assume you have a low, fixed rate mortgage. Second, we are assuming you are investing for the long term–at least 10 years. Third, we assume that your investments are well diversified. And finally, we assume that you are keeping investment costs to a bare minimum. Paying a financial advisor 2% to put your money in expensive mutual funds defeats the goal–to outperform the rate on your mortgage.
Furthermore, compare mortgage rates to investment returns is tricky business. As a starting point, you’ll want to factor in the tax savings on a mortgage if you itemize your deductions. For example, we had 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 with. If we compare it to current savings account rates, paying off the mortgage is a clear winner. Right now, the best rate 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 was 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.
Why Pay Off Your Mortgage Early
In light of the above, it does make sense to pay off the mortgage early in some cases. Recently I was helping a friend who lost her spouse. The decision she needs to make is whether to use insurance proceeds to pay off the mortgage. If she chooses not to pay off the mortgage, she’ll have trouble handling the mortgage payment each month. In addition, she’s not comfortable with the idea of losing money in the stock market, even with a solid investment plan. Finally, she believes she can meet her financial goals, most notably retirement in 7 to ten years if she pays off her mortgage. Under those circumstances, paying off the mortgage makes perfect sense.
My wife and I have also recently discussed this issue. She’s very much in favor of paying off the mortgage early. For her, it’s a feeling of security. This raises another important issue–what if a husband and wife don’t agree on the approach to take? It happens.
In our case, we quickly found common ground. We’ll use half of our extra money each month to put toward the mortgage, and the other have will go toward investments. This solution underscores an important part of personal finance–it’s rarely all or nothing.