There’s a somewhat natural aversion to debt and a desire to pay it down as quickly as possible. In many cases, that’s the financially optimal thing to do. By clearing debt off the books, you limit the amount of interest you pay, and in turn, free up funds to put toward your savings goals.
But, there is such a thing as good debt, and a mortgage is typically one example of it. You may think that putting more money toward your mortgage will help put you in a better financial position in the long run. However, when you consider the alternatives — namely, investing into tax-advantaged retirement accounts or paying down other, high-interest debts — paying off your mortgage early may actually cost you more than it saves you.
Of course, we recognize for many people there’s simply no greater feeling than making that final mortgage payment, knowing your home is 100% yours. Sometimes, it’s hard to put a price on that peace of mind and comfort.
So, which should you prioritize: paying off your mortgage as quickly as possible or investing extra cash? When making this decision, there are some important things you should think about:
- Your current mortgage term and interest rate
- Your monthly mortgage payment amount
- Your current retirement savings and long-term goals
- Your risk tolerance and comfort level with investing
- Your total cash flow and savings goals unrelated to retirement (emergency savings fund, home renovations, college education)
- Any other high-interest debt (credit cards, personal lines of credit, student loans)
Depending on your specific situation, there’s a case to be made for both paying off your mortgage early and investing more cash. As you evaluate the decision, here’s what you need to know.
Who can pay off their mortgage early?
For the most part, anyone with a mortgage and the financial means to pay it off is eligible to pay off their mortgage early. If you’re considering this, you will want to make sure your loan does not carry a prepayment penalty. These are atypical, but if you have prepayment penalties they are generally only assessed within the first three years of your mortgage.
You will also want to consider how you’re planning to pay off the mortgage. More specifically, where is that money coming from? If the money is in cash, then it’s a straightforward analysis. If it’s from investments, you’ll need to consider tax implications.
- If you’re pulling money from an IRA, you’ll have to pay taxes on that money when you take the distribution. And if you’re under 59.5 years old, you’ll likely have to pay an early distribution penalty.
- If you’re pulling money from a brokerage account, you will have to pay taxes on the growth based on the capital gains tax rate.
You want to be mindful of these taxes or penalties. The money you might be “saving” on interest from paying off your mortgage could be lost or more than offset by extra taxes and fees, not to mention the opportunity costs associated with having less money invested over time
How to pay off your mortgage early
When you sign a mortgage, all the terms are laid out: how long it will take to pay off (usually either 15 or 30 years), the interest rate (either fixed or adjustable), and the monthly payment amount. By sticking with the monthly amount outlined in the mortgage, you’ll reach your scheduled payoff date. But, if you pay more than that amount, you can pay off your mortgage sooner.
There are a few different strategies homeowners use to pay off their mortgage early. They all come down to one common factor: having extra cash to spend. For some, this may be in the form of a windfall (inheritance, gift, sale of a business, etc.) or increase in cash flow (significant debt paid off, a pay raise, etc.). Some of the most common strategies for paying off a mortgage more quickly include:
- Making biweekly mortgage payments instead of monthly
- Putting extra money toward each mortgage payment
- Putting any extra income (like tax refunds or year-end bonuses) toward the mortgage
- Refinancing to a shorter loan term (e.g., 30 years to 15 years) and potentially lower interest rate
- Paying off the remaining mortgage balance in one lump sum
At the end of the day, this is a decision about how you will spend your excess cash. Should you save it in your bank account, put it toward your mortgage, pay off other debt, or invest it?
Advantages to paying off your mortgage
For many people, paying off a mortgage can bring a great deal of peace of mind. In our work as financial planners, we find this to be particularly true for clients who are nearing or in retirement. Paying off your mortgage early reduces the amount of interest you’ll pay and gives you a feeling of prideful ownership: your home is yours, and it cannot be taken away. When you own your home outright, there’s very little risk of losing it as your income changes.
Compared to investing, paying off your mortgage certainly feels like the safer option. There’s not much risk in paying off your home, so long as you have the financial means to do so and a healthy cash flow. Investing, on the other hand, comes with an inherent risk, including potential short-term (and sometimes unpredictable) volatility and loss.
Advantages to investing instead of paying off your mortgage
You might think that paying off your mortgage is the financially optimal thing to do and would lead to saving more money over time. In fact, given the current interest rate environment, the opposite is most likely true: by paying off your mortgage early, you stand to lose more money than you save. When thinking about paying off their mortgage, many people only consider the money they’d save on interest. What they don’t often think about is the opportunity cost. That is, the growth they would have had if they had invested their money instead.
Higher rate of return and compounding growth
The long-term rate of return on strategic investments is much higher than most mortgage interest rates. And the longer you wait to put more money toward investments (i.e. by spending extra money elsewhere, like additional mortgage payments), the more time you’ll lose out on compounding growth. Your initial investment will grow, and that additional growth will also grow (and grow, and grow) for a longer period of time.
A hedge against inflation
Investing also acts as an inflation hedge more so than paying off your mortgage does. Because there is a higher rate of return with investing, your investments will grow faster and compound over time. Depending on the inflation rate, you’ll have a better chance of matching or beating inflation by investing. Additionally, keeping a long-term, fixed-rate mortgage places the risk of inflation with the lender that holds your mortgage. Even as costs rise, your interest rate will stay the same.
One final benefit of investing vs. paying off your mortgage is better liquidity. That is, investments offer quicker access to cash. Tapping into cash from the equity in your home can take some time, either by taking out a HELOC, doing a cash-out refinance, or selling your home. On the other hand, if you have money invested in a brokerage account, you can relatively easily and quickly sell stocks and bonds to get cash when you need it.
Leveraging good debt
Your mortgage is a type of “good debt.” That is, it leads to higher net worth accumulation over time. Home values almost always appreciate, so your home (and your mortgage) is an investment. Through leveraging, you’re borrowing money to fund an investment that will increase in value over time.
Leveraging for a longer period of time — for example, getting a 30-year mortgage instead of a 15-year mortgage, or paying your mortgage down over time instead of paying it off early — leads to larger wealth accumulation over the long-term. By leveraging the debt over a longer period of time, you’ll have more money to put toward investments, which are growing at a higher rate and compounding — all the while, your home is also appreciating in value.
What are the tax implications of paying off your mortgage?
The primary tax implications will be based on where you pull the money from to pay off the mortgage. As mentioned earlier, if you’re pulling from an IRA, you’ll have to pay taxes on the distribution amount. If you’re pulling money from a brokerage account, you will have to pay taxes on the growth based on the capital gains tax rate.
Additionally, there are a small portion of taxpayers who get a tax benefit based on the interest they pay on their mortgage. Because the Tax Cuts and Jobs Act (TCJA) of 2017 nearly doubled the standard deductions allowed, the group of people who actually itemize their deductions is much smaller.
Before the TCJA legislation passed, more people benefited from a tax standpoint by maintaining their mortgage and deducting the interest paid on their mortgage. In this case, the quicker someone paid off their mortgage, the less interest they would be paying, and the lower the tax deduction would be. Now, there are much fewer people who take itemized deductions, so it’s not as relevant for most people.
However, there continue to be significant tax advantages for investing into retirement accounts. Saving toward a retirement account lowers your adjusted gross income. Plus, if the money is in a Roth account or HSA, you’ll benefit from tax-free growth.
Other things to do before investing
It may sound like our only advice is invest, invest, invest — but that isn’t necessarily the case. If you have extra income, there may be some better ways to save it or spend it, including:
- Paying off high-interest debt (credit cards, student loans). Unlike mortgage rates, the interest rates associated with these liabilities are often much higher than the rate of return on investments.
- Building an appropriate emergency savings fund based on your level of job security and overall financial situation (we typically recommend an emergency fund equal to three to six months of expenses).
- Saving for pre-retirement goals, such as home renovations, a child’s education, or starting a business. For these types of goals, you don’t want your money tied up in retirement accounts.
Once you’ve checked off these boxes — and assuming you don’t have a high interest rate on your mortgage — you generally should focus on investing in this order:
- Maximizing an employer match on your 401(k) (if applicable)
- Maximizing your Roth IRA contributions
- Maximizing your HSA contributions (if you have a HDHP)
- Fully maximizing your 401(k) contributions
- Contributing any additional savings to a brokerage account.
Is it OK to have a mortgage in retirement?
There’s a common misconception that you should pay off your mortgage before you retire. The truth is, if you’re working with a good financial planner (or if you’ve created a solid financial plan on your own!), your mortgage payments will be factored into your retirement distribution plan.
The money you’ve spent years investing — instead of paying off your mortgage early — will have grown and will be available to you in retirement. Your investment portfolio will allow you to continue to comfortably make your mortgage payments and maintain your standard of living.
Conclusion: Should I pay off my mortgage early?
For most people, the short answer is no. As financial planners, we rarely recommend paying off a mortgage early. Given the current interest rate environment (even with anticipated increases this year), the expected rate of return you will receive by investing your money is very likely going to be higher than the interest rate you will pay on your mortgage. You’ll ultimately realize a higher rate of return and reap tax benefits.
When a client reaches out to us to express interest in paying off their mortgage, the first question we typically ask is, “Why?” Our responsibility is to remove emotion and provide objective advice to our clients (it’s one of the main reasons people hire a financial planner). We evaluate the mortgage, a client’s available assets for potentially paying off the mortgage, and show them how paying off the mortgage would impact their financial plan.
In almost every case, it makes sense to continue paying the mortgage on schedule. Paying off the mortgage decreases the ending investment portfolio value (with less money going toward investments and the loss of compounding growth). At the same time, paying off a mortgage early does not increase someone’s probability of successfully reaching their retirement goals, like ideal retirement age and retirement spending.
Of course, there are some instances where it makes sense to pay more toward your mortgage. For example:
- If you have a low risk tolerance and are searching for the safest option, paying off your mortgage is going to be better for you than investing — if for no other reason than for your peace of mind.
- If your mortgage rate is really high (similar to other high-interest debt).
- If you have a private mortgage insurance (PMI) premium attached to your mortgage. Once your equity reaches approximately 20%, PMI is removed.
- If you have an adjustable-rate mortgage (ARM) and the interest rate increases significantly. One way to prevent this from happening is to refinance your mortgage from an ARM to a fixed-rate mortgage while rates remain at near historic lows.
While we believe that, in most cases, strategic investing is more financially optimal than paying off your mortgage, we think it’s important to note that both paying off your mortgage and investing extra cash are ways toward building your wealth. While investing may be what’s best based on raw numbers in your financial plan, paying off your mortgage could be what brings you the most peace of mind. Everyone’s situation is different.
When making this decision, you want to consider all the factors. It may be a good idea to work with a financial planning team that can help you cover all the bases and evaluate the potential impact on your long-term financial plan. If you think that may be beneficial, we’re here to help. You can read more about our services and schedule a no-cost discovery call with us any time.