Things to Think About Before Deciding to Payoff a Mortgage Early
Many view debt-free homeownership as an important step on the journey to financial freedom and, eventually, a successful retirement. As housing costs increase across the country, particularly in and around major cities, being able to live in your home while only paying tax and insurance can go a long way toward keeping monthly expenses manageable.
You may be early in your mortgage obligation and are considering throwing a few hundred extra dollars a month at the principal. Perhaps you’re late in the mortgage term and considering just paying off the balance with a lump sum to be done with it. Regardless of life-stage, there are several factors that should be considered prior to committing to an early mortgage payoff strategy.
Don’t Even Think About It Unless You Do These First
A mortgage is often referred to as “good debt”. Mortgages typically carry a low interest rate and are a liability attached to a relatively stable asset that is typically expected to appreciate over time. Compared to most other liabilities, a mortgage is usually the “best” debt to hold onto. When considering the payoff of a mortgage, it is almost always wise to first pay off any other outstanding liabilities such as credit cards, auto loans, personal notes, or student debt.
Generally, funding a retirement account is a better use of financial resources than paying down a mortgage. Before considering paying extra toward mortgage principal, first maximize contributions to 401(k), IRA, and HSA accounts. The tax advantages of these accounts will almost always outweigh the benefits of reducing interest paid on a mortgage.
It is imperative to have 3-6 months’ worth of living expenses set aside to protect against unexpected expenses. It does no good to dedicate all available funds toward a mortgage only to be laid off or have the roof spring a leak causing credit card debt to stack up.
Finally, ensure that there is no penalty for pre-payments on a mortgage. While prepayment penalties are uncommon, getting hit with one can eradicate any value gained from paying off a mortgage early.
Mortgage Pre-Payment vs. After-Tax Investing
Today, most homeowners with a material balance left on their mortgage either started out with or refinanced to historically low interest rates. When working on financial plans for clients, it’s rare that we encounter a mortgage with an interest rate above 4.5% (though, with upward trending interest rates, that may be changing soon). At current levels, the expectation would be for market returns to outweigh the interest expense on a mortgage over the long-term in a prudently diversified portfolio.
Since 1980, the S&P 500 has returned 11.79% annualized to investors (data from Standard & Poors). This period even includes two major financial recessions. An annualized return of 11.79% handily outweighs the interest expense on a mortgage at today’s rates.
Obviously, there is no guarantee that stock investments will continue to provide returns at those levels. No one can reliably tell you how equity markets will perform over the next 10 years - or any time period, for that matter. If we just look at the first decade of this century, 2000-2009, the S&P 500 returned
-0.95% annualized. Over that decade, it would have been better to prepay a mortgage than to invest - but, hindsight is 20/20.
To further complicate this decision, a clever analysis of the economic impact of investing while carrying a mortgage balance reveals that this is really no different than leverage or investing on margin (albeit at generally favorable rates with less restrictive covenants). Observed through this lens, we have an entirely different perspective about the risk of such a scenario.
One significant drawback of mortgage prepayment is the sacrifice of liquid assets (the investments or cash flow used to prepay) in favor of an illiquid asset (your home). Liquidity is usually preferable to illiquidity.
As touched on above, there may be an event where significant assets are required for a need, such as medical expenses, home repairs, an investment opportunity, or legal fees. A credit card, personal loan, tapping a retirement account, or even a home equity line typically carry a greater cost than the interest expense paid on a conventional mortgage.
If there are still adequate liquid resources available after funds are utilized to pay off a mortgage, then this may not be a significant factor in decision making.
Tax Deduction For Mortgage Interest Paid
Following the passage of the Tax Cuts and Jobs Act, the tax deduction available for interest paid on a mortgage has become a lot less attractive to most people. While the deduction for mortgage interest was left intact in the final iteration of the law, other deductions that were often paired with the mortgage interest deduction were neutered or outright eliminated. This, combined with an increased standard deduction, creates a scenario where most mortgage-holders will not be claiming a deduction for their mortgage interest unless they also claim significant deductions for medical expenses or charitable donations.
However, for families that do claim other deductions in-excess of the standard deduction, the ability to deduct mortgage interest can offset a decent percentage of the household’s interest expense.
For example, take the following assumptions:
- At least $24,000 in itemized deductions other than the mortgage interest deduction
- Mortgage Interest Rate: 4.00%
- Income reported in the 32% marginal tax bracket
When accounting for the benefits of the mortgage interest deduction, the actual, tax-equivalent interest rate paid comes out to 2.72% - not 4.50%. In most cases, the real tax equivalent rate is even more favorable once deductions for state and local taxes are included.
Risk-Free Return of Pre-paying a Mortgage
Mortgage pre-payments are economically equivalent to risk-free investment performance at the effective interest rate of the mortgage. What I mean by this is if the tax-equivalent interest on a mortgage is 2.72%, then every dollar prepaid toward principal on the mortgage is the same as buying a bond with a guaranteed return of exactly 10%.
In our current interest rate environment, 2.72% risk-free interest is pretty nice (though, if interest rates continue to rise, this becomes less attractive). At the time of this writing, a quick Google search suggests that 12-month CDs can be obtained in the 2.00-2.50% range. Depending on your personal risk aversion, having access to effective risk-free return can be very desirable.
Emotional Feelings on Debt
Some people just don’t like the idea of being in debt. Yes, a mortgage is often a valuable tool that can be used in accomplishing financial goals. However, if the emotional burden of owing money and being beholden to a lien stresses you out or doesn’t sit well with you - that’s okay!
Assuming you have satisfied the qualifiers discussed earlier, the benefits of carrying a mortgage may not outweigh the corner of your emotional well-being the debt occupies. If this is the case, then it might be perfectly reasonable to consider prepaying a mortgage. Even though mathematically pre-payment may not be the best decision, psychologically, it just might be.
How Will the Extra Cash Flow From a Paid-off Mortgage Be Used?
What’s the ultimate goal for paying off a mortgage? If it’s piece of mind or financial freedom, then this could be a worthy pursuit. If it’s the opportunity of taking a more expensive vacation or some other spending-related pursuit that would be possible without a mortgage payment, then this may not be such a great idea.
Crucially, this entire discussion assumes that there is a binary relationship between saving/investing and applying funds toward mortgage prepayment. The goal is to save the money currently funneling into mortgage principal and interest. If the reality of a paid-off mortgage results in increased spending with the additional cash flow created, then this ends up being a negative economic proposition.
If the funds that were previously directed toward a monthly mortgage payment are now used to fuel vacations or extra nights eating out, then all you’ve really done is tap your savings or investments to pay for those vacations or nights out - the mortgage payoff was just an intermediary to justify the expense.
Making a decision to commit a large sum of money on a monthly or lump-sum basis can carry great financial implications. The discussion above is some general things to think about and can act as a rough roadmap to making a decision. At the end of the day, your situation is unique. It may be wise to talk with your financial advisor to really analyze what makes the most sense for you.
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