Not many enjoy having a large mortgage looming over their heads and racking up interest for up to 30 years. As a result many with extra cash look to pay off their mortgage as soon as possible. However paying your mortgage off early may not always be the best decision. There are two types of debt, good debt and bad debt.
While some may think no debt is good debt, a mortgage is considered good debt since it grows in value or income over time. Here are five things to consider if you are tempted to pay down your mortgage early. Click here to calculate your mortgage with a mortgage calculator and click here to calculate if you should refinance or not.
- Your home doesn’t provide income. Purchasing a home used to be the pinnacle of The American Dream. The 2008 financial crisis proved otherwise when many were left underwater with their mortgage worth more than the home itself. When you put all of your money into your home, it may increase your equity, but unless rented out won’t provide income and could take years to grow in value. When you invest in the stock or bond market, you have the potential to gain an income stream through dividends, interest payments, and capital gains. The main goal for investing is to provide enough income so you don’t have to work! If you have a high interest rate, then it may make sense to pay your home mortgage down, however even with the recent interest rate hike, we still are at historic lows in terms of interest rate. If you have a low interest rate, you can take advantage of it by generating higher returns elsewhere and keeping the difference. If you are able to get an average of 8 to 12% over the next 30 years in the stock market, you will most likely end up with more assets versus paying off your mortgage.
Let’s say you have a $500,000 mortgage with a 3.5% interest rate. Over 30 years, the total interest paid will be $308,000. This is a lot of money, so it’s natural to think that any extra cash should go toward paying down your principal. However, let’s say you keep your regular 30-year payment schedule, and invest $600 each month – enough to max out your Roth or Traditional IRA – and earn a reasonable 8% return. In that case, your portfolio will grow to almost $900,000 by the time you’ve paid off your mortgage! So if you have a relatively low interest rate, then clearly it can pay to hold on to that mortgage, continue reaping the tax benefits, and investing your spare cash.
You won’t be able to use the interest deduction. The one benefit of mortgage interest is the sizable tax deduction. If you are in a high tax bracket, losing this deduction could mean paying more taxes and potentially push you into a higher tax bracket, resulting paying more taxes. For example, if you are in the 25% tax bracket pay $24,000 mortgage interest per year, that’s a $6,000 tax break that you will be giving up by paying off your mortgage. If your state tax is 7%, that tax break can be $8,000. This makes sense if your mortgage deduction is over the standard deduction.
You may have limited liquidity. As we saw in the 2008 financial crisis, the housing market isn’t very liquid. It takes a lot of time to buy and sell a home that could last up to months. If all of your liquid cash is in your home, then you may have difficulty paying any big expenses that may come up. Life events like medical emergencies, college, and marriage require liquid assets and you don’t want to sell your home in order to get it. If you instead take the money you’d use off your mortgage earlier and instead invest in diverse investment portfolio, you’ll have more options should the need for cash arise. You want to make sure your emergency fund is fully funded. Also if there is a chance that you may move, it may be a smarter move to hold onto your cash and not be tied down to a mortgage.
Your mortgage is an inflation hedge. If you have a fixed interest rate over 30 years, inflation will act in your favor. The bank takes all of the risk here since they can’t call the loan like a bond as long as you make all of the payments. This means you have a fixed payment over 30 years. When you take inflation into account, 20 years from now your mortgage may be like a car loan today! For examine, let’s say your mortgage is fixed at $2,000 per month for 30 years. Your mortgage payment 30 years from now assuming inflation is at 3% will be equivalent to only $823.97 today! As your home value increases over time, you are essentially paying less for your house since your payments stay the same. You are getting more value for your buck.
- You have high debt and not maximizing your retirement savings. If you have a low interest rate mortgage but have credit card or student loan interest rates, then it doesn’t make sense to pay down your mortgage. Pay down the high interest debt first. In addition, you may be able to borrow to buy a home, but chances are you will not be able to borrow for retirement. If your employer matches your retirement 401(k), take advantage of that free money and at a minimum invest up to the match. It is a triple bonus if you invest it wisely, free money, leverage by investing the difference, and the tax deduction.
Everyone’s circumstances are different, so before making any decision, it is best to look at the numbers, your financial goals, as well as your personal preferences. If any type of debt, good or bad, gives you ulcers, or you are close to retirement, than paying it off sooner may be the answer. But if retirement is still some time away and are comfortable putting your spare cash to work in the market, you may end up growing your wealth faster.