If you own a home, it’s often thought that you should pay off your mortgage as quickly as possible. This is often advisable. A mortgage is frequently the largest amount of debt most people will ever owe, and even a terrific interest rate adds up quickly. So all things being equal, it often is wise to pay that off. However, if you urgently need to boost your retirement or emergency funds, or if you have corrosive debt like an unpaid credit card, it can make sense to delay paying off your mortgage. Here’s how to approach it. Consider working with a financial advisor as you consider how best to handle your mortgage.
Why You Might Want to Pay Off a Mortgage
Don’t be fooled by the relatively small numbers. The interest rates on a mortgage involve enormous amounts of money. Nationally, the average mortgage is around $275,000. At time of writing the average interest rate on a 30-year home loan was 4.146%. Your monthly payment on this mortgage would be $1,336.78. For the first payment, only $385.74 would go toward paying off the principal. The rest, all $951 of it, would be a pure interest payment. Next month, again you’ll pay $1,3336.78, and again approximately $950 of that money gets eaten up by interest.
Interest payments don’t reduce your debt or improve your finances. As far as your money is concerned, you might as well just set that cash on fire. In our example mortgage above, you’ll make that fixed payment of $1,336 every month for 30 years, but it will take 13 years before more of that payment applies to your principal than your interest. By the time you’re done you’ll have paid $275,000 for the house and $206,242 on interest. The faster you can pay off your mortgage, the less money you’ll spend on interest. And when we’re literally talking about hundreds of thousands of dollars, this is a big deal.
As a result, financial advisors often recommend that homeowners pay down their mortgage as aggressively as possible. The faster you pay off this mortgage, the less money you will spend on interest. What’s more, paying off your mortgage will virtually eliminate your housing costs. From that point on, all you’ll have to worry about is a few thousand dollars per year in property taxes. You can move, or not move, as your lifestyle sees fit, but it will put you in the driver’s seat. In other words, if finances allow, it’s usually a very good idea.
Why You Might Not Want To Pay Off a Mortgage
All of that said, sometimes it might actually be a good idea hold off on those early or extra payments. Paying off your mortgage early means dedicating extra cash each month to reducing your mortgage. Remember that your contract with the bank is a contract. It can’t increase your principal, and unless you have a variable interest rate it can’t increase your payments. This is a fixed, known expense that you can plan and budget for. There are four common rationales for not paying off your mortgage early.
This is probably the most compelling example. Most Americans don’t have enough saved for retirement, and sooner or later that will become a crisis for each individual household without enough money. This is particularly true if you’re in your 30s or 40s. With several decades left to build wealth in your IRA or 401(k), you still have enough time to build up a solid nest egg, but you need to get started now.
Make a retirement plan, then see where you are. If you need to make catch-up contributions, it might be very wise to prioritize those over accelerated mortgage payments.
Credit Cards and Student Loans
Unlike a mortgage, this is all unsecured debt. If you want to move, you can sell your house and (hopefully) use those proceeds to pay off the mortgage. Nothing short of bankruptcy can make credit card debt go away, and when it comes to student loans not even that.
Student debt, meanwhile, has average interest rates of between 4% and 7%. These are higher interest rates than most mortgages, and often apply to five- or six-figures of debt. If you owe $90,000 at a 7% interest rate, it can erode your finances with breathtaking speed. The debt on a credit card compounds quickly, while a student loan is essentially like carrying a high-interest mortgage. Both are worth prioritizing.
The rule of thumb is that your emergency fund should have anywhere from four to six months’ worth of living expenses saved up in it. This is too ambitious for man people; saving up half a year’s income in cash is a big lift. However, you should be able to get by for a while in case of job loss, and you need to be able to handle unexpected expenses. This is particularly true if you’re a homeowner. You don’t want to get caught flat-footed if a pipe bursts or the roof starts to leak.
Like with your retirement account, make a plan. Identify an amount of emergency savings that you feel like you can realistically achieve, then begin to save up. It’s appropriate, indeed wise, to prioritize those savings over accelerated mortgage payments.
A Strong Market
If you have a low interest rate on your mortgage, it is very possible that no- or low-risk investments will offer better returns than the interest rate of your loan. For example, a market-indexed mutual fund or ETF is often considered a fairly low risk investment when held over a long period of time. Month-to-month, the S&P 500 may fluctuate, but so long as you’re willing to hold your portfolio for a period of years this is generally a very low risk choice.
In a case like this, it is true that you will make more money by investing in the low-risk asset than you will save by paying off your mortgage early. For example, say you have a 3% interest rate on your mortgage and the S&P 500 is posting returns of 5%. Every dollar you spend on your mortgage will save you $0.03, but every dollar you invest in an index fund would gain you $0.05. The index fund would come out ahead by $0.02 per dollar. Just keep in mind that long-term stock market returns can be fickle and your debt is fixed. The returns that you’re investing for today may not be as strong in 10 or 15 years, while your interest rate will tick away year by year.
The Bottom Line
Paying off your mortgage early is usually a good idea, but in some cases you’re better off putting your money elsewhere. This is particularly true if you have urgent, unmet financial needs, such as catching up with retirement savings or paying down toxic debt. It’s also sometimes the case if you see an obvious type of arbitrage opportunity: a discrepancy between what can reasonably be expected from the stock market contrasted with your mortgage’s interest rate.
Tips on Mortgages
- Do not risk becoming “house rich.” This is the term for someone who has a valuable home, but because it soaks up all their money they have no cash on hand. Take a spin through our mortgage calculator to figure out how you can hit that perfect middle ground of a great home and great finances.
- Are you thinking about buying a home? Be sure and work with a financial advisor to ensure you handle this big step wisely. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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