With interest rates increasing, paying off your mortgage early might seem like an attractive prospect.
It certainly sounds like a good idea. After all, it gets rid of a large monthly payment, frees up cash flow, and stops those annoying interest charges in their tracks. What could be better?
The truth, however, is that the situation is a bit more nuanced than that. If long-term wealth building is your goal, then it’s important to think about more than just what you’d gain by paying off your mortgage – but also what you could lose.
Here are a few pros and cons to consider if you are thinking about putting extra funds toward your mortgage.
Pros to Paying off Your Mortgage Early
1. You will save money in interest
The faster you pay off your mortgage, the less you end up paying in interest overall. Extra mortgage payments can shave years off your mortgage and tens of thousands of dollars in interest paid over the life of the loan.
Take a look at the example below for a comparison of how much interest you would save if you put an extra $500 a month toward your payment on a $300,000 mortgage with a 3.25% interest rate.
As you can see, you wouldn’t have to put $500 extra toward your mortgage payment for 20 years because the loan would be paid off in 18 and a half. Putting that extra money toward your mortgage would also mean you would save over $70,000 in interest for use or investment elsewhere.
2. You will build equity in your home faster
Every time you make a mortgage payment, part of it goes to interest and part of it goes to paying down your principal or building up your equity. Any additional payments you make on your mortgage will go to building that equity as well. Equity is important because it gives you the flexibility to do things like take cash out of your home, which you can only do once you have more than 20% in equity.
3. You will lower your debt
For many people, being debt-free is synonymous with financial success. Owning your own home outright and knowing you don’t have this debt hanging over your head can help you feel better about life and your financial situation, and it can give you peace of mind in retirement.
Getting rid of a monthly liability will also lower your debt-to-income ratio (DTI). Because DTI is a key metric whenever you want to borrow money, a lower raito means you’ll be able to be approved for more if you need to get another loan or credit card. Plus, the closer you are to debt-free, the better your credit score will be.
4. You will be able to score a lower rate on a refinance
If you build up equity and lower your DTI, you will be able to take advantage of lower interest rates based on having more equity while showing less of a debt burden. That means if you want to pull cash out of your home or refinance to better loan terms, you are more likely to be approved for a competitive interest rate.
Cons to Paying Off Your Mortgage Early
1. You may lose out on better returns elsewhere
Paying off your mortgage will save you a quite a bit in long-term interest (shown in the graph above). But will those savings amount to more than you’d make in the stock market? Or with another real estate investment? Or buying some cryptocurrency? That’s where you should take a beat and do some careful calculations.
Let’s refer back to the sample above and say you decided to invest that extra $500 in an index fund instead of your mortgage. According to Investopedia, the S&P 500 has an average annualized return of 10.67% dating back to 1957.
What would happen if you started from nothing and invested $500 per month in an index fund tied to the S&P 500 for 20 years? Because the stock market has its ups and downs, we’ll account for this by using a benchmark 10.6% return with a 4% variance.
If you’re willing to take on more risk, you can likely get better long-term returns in the stock market than by paying off your mortgage early. If we assume a rate of return even at the low end, you would be more than tripling the amount of money you would have after 20 years if you invested the money rather than putting it toward your mortgage.
2. You will lose an inflation hedge
As we’ve discussed previously, owning a home with a mortgage helps insulate you against the impacts of inflation.
If you have a fixed-rate mortgage and you are making the same payment over 15 or 30 years, you have the benefit of paying back that debt in watered-down dollars during times of inflation like we are in today. What’s more, if the rate of inflation exceeds the interest rate of your mortgage, your lender is effectively paying YOU to borrow money!
3. Your liquidity will decrease
Liquidity refers to the ease with which an asset can be converted into cash. When you put money into your home, the liquidity of those funds significantly decreases as you need to go through a cash-out or HELOC process to access them.
It’s important to have liquidity to handle the emergencies that arise in life: a new roof, a health crisis, a child that needs help. If paying off your mortgage quickly will leave you without any cash, you may be better off doing so over a period of years.
4. You’ll have fewer tax deductions
One of the benefits of having a mortgage is being able to take advantage of the home mortgage interest deduction. If you itemize your deductions, you can deduct the interest on mortgage balances up to $750,000.
If you make big strides to pay down your mortgage or fully pay it off, it eliminates or substantially reduces the benefits of this deduction.
The Bottom Line
As with most things in investing, the answer is in your personal goals as well as your tolerance for risk.
Paying off your mortgage can be a load off your shoulders. If peace of mind and savings in the bank is your goal, then don’t hesitate to knock out that debt as fast as you can.
If you are less worried about debt and your goal is long-term wealth building, it might be important to step back and do some careful evaluations before tacking on that extra money to your payment. Would paying it off or investing make you more? Are you willing to chance the money in the hopes of doubling or tripling your returns?
You could also consider doing a little bit of both. Paying extra toward your mortgage versus investing doesn’t have to be an either-or decision. If you have a significant amount of extra money in your budget, you may choose to make a smaller extra principal payment and also put more money into a retirement account or other investment.
Deciding where to put your money to best meet your goals can be daunting. If you are having trouble deciding whether to pay down your mortgage or invest elsewhere, we recommend reaching out to your NEO mortgage advisor. They will be able to crunch some numbers and give you a simple breakdown of how different investment strategies will affect your financial goals.