Despite what you may have heard about paying off your mortgage, there is no one-size-fits-all answer to this question. This is because the answer to this question comes down to YOU, your goals, your values, your wishes, and your desires.
So, should I pay off my mortgage?
In this article, we will discuss the framework that can help you identify the variables to consider before answering the big question yourself.
By going through different scenarios where it's a good idea to pay off your mortgage early and others where it would not be beneficial, you're able to see all sides of the equation.
If you decide paying off your mortgage early is the right decision, I'll share three strategies to help expedite paying off your mortgage ahead of schedule.
Misinformation About Paying Off Your Mortgage
First, it's important to understand the disadvantage we have in regard to information regarding
mortgages. Everyone seems to have a different opinion on this topic!
Since we gather we information from the news, the bank teller, family, coworkers, friends, etc., we're receiving a variety of input from sources with little-to-no knowledge of our personal finance goals.
Would we or should we take advice from those with different personal financial situations and/or who don't share any alignment with or know our goals? Probably not.
Early mortgage payoff considerations are a classic case of putting your blinders on and doing what YOU need to do.
Mortgage Principal vs Interest Payments
Before deciding whether or not paying off your mortgage early is a good idea for you, we need to know exactly how a mortgage works.
Assuming you have a traditional mortgage, every time you make a mortgage payment, you pay two different parts of the home loan—the principal and interest. Early in your mortgage, you're paying mostly toward the interest and very little to the principal balance. Then toward the end of your mortgage, a more significant percentage of your payments go straight to the principal and less to interest.
Your loan may include an escrow account depending on your agreement with the mortgage lender. Escrow is a fancy way of saying "savings." Your escrow account accumulates a portion of each of your mortgage payments and holds that money until insurance, taxes, and other required items are due.
You always have the option to pay more toward the principal balance to accelerate your home equity. Some mortgages are even structured, so any extra money you send is applied directly to the principal. However, each loan is different, so it's important to look at your mortgage statements, rate, and how much of your payment goes toward principal, interest, and escrow.
Should I Pay Off My Mortgage Early: The Framework
You need to consider several factors before deciding to make regular mortgage payments long-term or if you should pay off your mortgage early. This section will highlight some of the main things you should consider before making this big decision.
How Long Are You Planning on Living in the House?
First, you need to consider how much longer you plan to live in the house. Will it be less than five years or more than five years?
If you're planning on selling your house within the next five years, paying off your mortgage early isn't going to have many advantages, if any. Making extra mortgage payments will only hinder your cash flow, especially if your timeframe to relocate is less than two years.
On the other hand, if this is your forever home, or you're going to live in the house for at least five more years, then it's absolutely to your advantage to consider paying off your mortgage. This is especially true if you imagine having no mortgage payment, you feel elated and excited about what you could do with that cash each month.
How Does Your Income Affect Your Mortgage Payment?
The second consideration is your income level. How much are you currently bringing home each month? How does that compare to your loan expenses?
It used to be that people would claim they didn't want to pay off their home early because they enjoyed the tax deductions. However, the standard tax deduction in the US is now so high that keeping a home loan just for the mortgage interest tax deduction may no longer be beneficial.
If your mortgage payments feel like a financial burden, it might be time to explore refinancing if you have a high interest rate or downsizing or relocating to a more cost-friendly area.
For example, we're seeing a big shift in Californians moving to Texas and other Southern states in the US. Families are moving to states with low- or no-income tax and scooping up beautiful properties at much lower prices, which is helping them save money and ditch high interest debt all at the same time
Savings Account and Lump Sums
The next step is to determine whether you have enough in your after-tax savings accounts for your family's routine expenses plus other entertainment, vacations, and activities you desire.
First, ensure your emergency/rainy-day fund, or as I like to say – Adventure Fund, is adequately supplied. If you are single or in a single-income family, you should aim for at least six months of net spending in the account. If you are in a dual-income family, aim for at least three months of net spending reserved in the account. Once this fund goal is achieved, funnel extra cash into long-term savings, investments, and retirement accounts.
You'd be surprised how many people don't seek a financial advisor until they inherit money, sell a large asset, or receive a large lump sum. So, naturally, this is one of the first questions they ask: Should I use this to pay off my mortgage?
If you receive a large lump sum, the first order of business is to ensure your savings accounts are in order. Then, once you have the money where it needs to be, you can look at your mortgage loan and your extra cash to decide if paying off your mortgage early is the correct decision based on your personal and financial goals.
Mortgage Loan Structures and Mortgage Interest Calculations
Take a closer look at how your mortgage is structured and what your obligations are from this point forward.
What is your mortgage rate?
Is your mortgage loan on a fixed or variable rate?
How many more monthly payments are due?
What is your mortgage balance?
How much is your home worth?
Are you paying PMI?
Mortgage rates can vary, and the mortgage interest rate you have from your mortgage lender might be much lower than the mortgage interest rates currently, so it is worth comparing current interest rates to the one on your current loan term.
PMI stands for Private Mortgage Insurance. PMI helps protect the lender of the mortgage in case you stop making payments on your loan. Mortgage insurance is a fee you owe directly to the lender because they loaned (in most cases) more than 80% of the value of the home at the time of the deal.
Your monthly payments will be higher with PMI; therefore, you want to remove it from your mortgage or refinance your loan as soon as possible to eliminate this and any other extra loan expenses. Some lending services will remove it, but only if you pursue the removal, while others require you to refinance.
Ask yourself these two questions:
1) What are your goals?
2) What is your vision for your future and your home?
Your personal goals, values, and what's important to you are the most important parts of deciding what to do with your mortgage. Your goals should drive your decision on what to do next.
Here is an example: A friend of mine had a goal of having no mortgage payment at the age of 40. She and her husband both had very high incomes, but they still would not be able to pay off their loan by her 40th birthday.
They chose to sell their home and purchase a much smaller home in cash. The equity earned from selling their original, much larger house plus some of their savings completely paid off their new home.
This is one example of an extremely creative way to pay off a mortgage sooner, rather than later. While I don't recommend this for everyone, this was the perfect move for her.
She had a very clear goal, and she and her husband worked together to make it come to fruition. You'll need to get clear on your own financial goals and determine if paying off your mortgage early is right for you.
Early Mortgage Payoff Scenarios
Now that we have set up the framework to help you choose to pay off your mortgage early or not, let's look at a couple of common scenarios homeowners go through on making this big decision.
*In each of these scenarios, I'd always want more information about income, assets, and other financial details so that together we could make the best decision for your unique financial situation.
Scenario 1: Small Principal Balance: You owe a small amount on your mortgage, let's say less than 50,000.
My Advice: Yes, you should pay off your mortgage, especially if you have received a lump sum from an inheritance or the sale of a business.
Scenario 2: Forever Home: You are in a home that checks all the checkboxes, that you could see yourself growing old in, and that you can't imagine why you'd ever move.
My Advice: This is a big yes, it is the right decision to no longer have a monthly payment and pay your mortgage loan early.
Should I Pay Off My Mortgage Early, Or Should I Invest?
There's a lot of debate based on this question, which is usually asked when someone has received a large lump sum. I often tell my clients to pay their mortgage off rather than invest.
Most believe the return rate on investments will be higher than the interest you pay on the loan. Even though you will pay some income tax on your investment gain, you'll also receive a little tax deduction for the interest, at least depending on how much you owed in prior tax seasons.
Theoretically, you would be a little bit better off investing, but I still feel strongly that using those funds to pay off your mortgage is a better and more conservative choice. I look at it this way: you can sleep in your house but can't sleep in your brokerage statement.
I think there's a higher benefit to protecting your home where you live than maybe making a little more money. If you invest the money you were going to use to pay off your house, and then a recession hits, you lose your job, or several unforeseen circumstances come into play, causing your investment to go down, that would be disastrous.
In my opinion, avoiding a devastating scenario is a better choice; therefore, paying off your mortgage is a higher return on your investment, in my opinion.
Should I Pay Off My Mortgage Before I Retire?
First, you need to know most mortgages are on fixed terms and have a payoff date. So, it will typically be paid off at some point before or during retirement.
There's absolutely nothing wrong with having a mortgage when you retire, especially for those who have most of their retirement savings tied up in tax-deferred vehicles like 401ks or IRAs.
If you want to pay off your mortgage before you retire, but that would require pulling funds from a tax-deferred vehicle, the tax consequences can get very high very quickly. This could be a risky choice and is generally not recommended.
This situation comes down to your personal preferences. It may work as long as you set an appropriate budget for the payment in your retirement plan and retirement cash flow.
Three Ways to Pay Your Loan Early
Once you have made the big decision to pay off your mortgage early, you might be wondering how to knock down that big chunk of debt!
Here are 3 options:
You can explore selling your home and using the equity from the sale to pay cash for a smaller home. You might explore smaller homes in your neighborhood or get adventurous and consider an area with lower housing prices. Sometimes it works out so that people can buy an equivalent-size house to the one they just sold and become mortgage free.
The next idea for paying off your mortgage early is to make extra payments to the mortgage principal balance. One of the typical rules of thumb is if you can make an extra mortgage payment once a year, you'll pay off your mortgage several years faster than reflected on the original loan term. Depending on your interest rate, that could be anywhere from three to five years faster just by making one additional monthly payment per year.
Lump Sum Windfall
The third and most common way is if you have received a lump sum like inheritance or earnings from the sale of an asset.
A word of caution here is it depends on the type of lump sum you receive. If your lump sum came from an IRA or 401k, those are seen as taxable income and subsequently have high tax consequences for withdrawing a large sum.
If your lump sum is taxable, you might want to space out your withdrawals and only take out a certain amount each year. You also want to see if there is an amount you can withdraw that will put you right below the next tax bracket to save you from paying more taxes in April. When looking for this amount, you want to talk with your financial planner, CPA, or accountant.
Is It Worth Paying Off Your Mortgage?
Is it worth paying off your mortgage and no longer having that recurring monthly bill?
It all depends on your goals and what makes financial sense to you and your family.
First, remember you want to have enough money to fund an emergency savings account with 3-6 months' worth of household expenses. Before getting rid of your mortgage, this should be in a high-interest savings account or other liquid, highly accessible account. Then, if you have a little extra cash flow at the end of the month and can easily throw it at your mortgage.
Next, look at the interest rates of any other debts you may have, such as student loans, credit card debt, and any other personal loans. If you're carrying higher interest debt than your mortgage, you would want to pay those off first since this will save you more money in the long run than your mortgage.
Before deciding to pay off your mortgage, check with your mortgage lenders to see if your mortgage comes with any prepayment penalties.
Paying your mortgage should never be a financial burden, and you do not want it to feel as though you are putting all your money into your house. If having your mortgage paid makes sense to you and you have the liquid cash to do so, then do it!
In conclusion, remember, it is all about financial planning and finding the path that best suits your goals!