Should I pay my mortgage off early? is a common question I’ve read across a bunch of personal finance articles and there’s definitely a lot of debate as to whether or not this is the right thing to do. Personally, I think that if you cut through all the noise and if you own a traditional 30-year fixed mortgage where the payments aren’t bleeding you dry, I think the answer is actually pretty simple: No, because assuming you have a stable job and plan on living there for awhile, you can get a much better return by keeping those extra dollars in the stock market or even buying a rental property. However, personal finance is never that easy, there’s always nuance and unique situations, etc.
In this article, I will explore some things you should consider when making this decision as well as some pros and cons of paying off your mortgage early. The perspective that I will be taking is one from a FIRE perspective with the ultimate goal of retiring early.
Things to consider on whether or not it makes sense to pay off or pay down your mortgage early
1. Does having less monthly mortgage payments give you more peace of mind?
If the answer to this question is “Yes” then I think many people in this camp will likely choose to pay off their mortgage early since debt can be a burden especially if it’s a large monthly payment.
Not to mention, having no mortgage can really free up cash flow since generally your monthly mortgage bill probably makes up the bulk of your monthly living expenses. Having that much more ample cash flow can really be good for someone’s financial psyche.
For those that are pursuing FIRE, I implore you to realize that low interest rate debt is good debt as long as it’s manageable in your overall monthly budget.
2. Do you have a low interest rate on your mortgage?
The lower your mortgage rate, the more you should consider just paying the monthly minimum mortgage payments because a low fixed interest rate on your mortgage can act as an inflation hedge especially as interest rates start ticking up in the coming years. I personally think any fixed rate that is < 3.5% is considered “low” and should warrant serious consideration on whether or not it makes sense to pay down or pay off the mortgage early.
The reason why a fixed rate is an inflation hedge is because money becomes less valuable as the years go on due to annual inflation and having a fixed monthly principal and interest payment of $X will mean that as time goes on and inflation kicks in, your monthly payment will remain fixed despite those dollars being less valuable.
For example, if you had a mortgage from 2009 after interest rates tanked and your mortgage payment is $1,000/month, in 2021 dollars, that monthly payment is equivalent to $1,214.12 using this one calculator, so your dollar is 21% less over 12 years, imagine what happens to your dollar value in 30-years? Per that calculator, $1,000 from 1999 would be worth $1,912.44. Granted, interest rates were way higher back in 1999 but you get the point.
In addition, we are currently in a low interest rate environment, interest rates will eventually go back up like they did back in 2015-2019 when the Fed started to slowly increase the federal funds rate. That means, in the next 5-10 years, interest rates will go up, which means that savings yields or intermediate bond yields will go up. There is a strong possibility that in the next 30 years, the yield on a low duration high credit rating bond or even savings account could be higher than your current mortgage rate which means you could be making more investing in something basically risk-free that could then be used to pay off your mortgage interest.
Just prior to the pandemic, the yield on some safer bonds ranged from 3-4%, even low duration bonds were yielding 2-2.5%.
3. Do you have other debt with high(er) interest rates?
My rule of thumb is that you should always pay down your high interest rate loans first. That usually means credit card, student loans, etc. Any loan over 5% should be paid off ASAP before you even consider paying down your mortgage (this assumes your mortgage rate is < 4%, if it isn’t, you should definitely consider refinancing).
4. Are you maxing out your 401k or retirement accounts or at least getting the maximum company match on your 401k contributions?
As of 2021, the maximum 401k contribution is $19,500 and IRA contribution is $6,000. At a minimum, you should be contributing enough to get the maximum company match for your 401k since this is FREE money. If your company doesn’t have a 401k match, you plan on working to at least age 59.5 and you are a passive investor, then I think you should really consider contributing as much as you can to your 401k since the pre-tax savings is really helpful especially if you’re a higher income earner with a higher marginal tax bracket.
5. How are you planning on funding, paying down or paying off your mortgage? Remember the tax consequences when selling investments from your brokerage account.
Let’s say you have the money to pay down a large chunk of your mortgage or to pay it off fully, where will the funds come from when you choose to pull the trigger?
If you’re pulling from investment accounts, then be ready for a tax bill that could be pretty big since you’re planning on making a big payment. Federal taxes from your brokerage account can be as high as 40.8% if it’s a short-term capital gain (37% max rate + 3.8% medicare surtax) and that’s not even including state income taxes, so after you drop a wad of cash on that mortgage loan, be ready to have estimated tax payments ready or a big tax bill come April 15.
6. Will there be a prepayment penalty for paying off your loan early?
It’s hard to say how much the prepayment penalty is and you’ll have to take a look at the fine print and ask your bank, but I think what would really suck is if you make a big payment to pay off your mortgage and then get hit with a several thousand dollar fee for paying off your mortgage early. Fees are the worst and there are better ways to use that money.
7. What’s your overall financial goal if you choose to make this decision?
Is your goal to simply reduce your monthly payments? If your current interest rate is high enough, it might make more sense to just refinance to get a lower payment with no real cash payment. If you can save 0.5% or more on a $200k+ loan, generally, you can reduce the monthly payment by a reasonable amount to make it worthwhile to refinance. Also, perhaps you already have a low interest rate and just want to save on cash flow every month, another option that may help you reduce your payments without having to pay off the mortgage fully is to do a mortgage recast, which is basically a lump sum payment towards your mortgage loan that enables you to re-amortize the loan with a new loan balance without “restarting” the fixed term. A mortgage recast only costs about $200-300 also vs. a refinance which generally costs a few thousand dollars.
For example (using made up numbers and figures):
- You have a 30-year fixed $200k mortgage with a $1,000/month mortgage at 3.0% with 20 years remaining on the mortgage.
- You pay the bank a lump sum of $50k to recast the mortgage and you keep the 3.0% interest rate and the 20-year term remaining and drop your monthly payment to $650/month, so a savings of $350/month
A mortgage recast is something that not a lot of people know about. Most people know about refinancing but refinancing always resets the clock on your mortgage plus it’s kinda pricey especially with that new 0.5% adverse market refinance fee that will hit most refinances. A mortgage recast again costs only a few hundred dollars and doesn’t take a long time. I personally did a mortgage recast on my rental property and it took just a week or so for all the paperwork to be completed which is way faster than a refinance.
8. If you pay down or pay off your mortgage, you may lose some tax benefits
One of the nice things about having a mortgage is that you can deduct the interest expenses you pay on the loan every year from your taxes and this is generally a big number especially in the first 5-10 years of the mortgage. Of course, this is only if you are itemizing your deductions.
If you pay down or pay off your mortgage early, you may have less interest to deduct which may cause you to lose the ability to itemize your deductions since it may be better simply to take the standard deduction which is a hefty $24,800 for married couples filing jointly or $12,400 for singles. So if you’re already on the cusp of choosing between the using the standard deduction or itemizing with the interest expenses, you may lose the ability to write off charitable donations and what not going forward.
9. What’s the opportunity cost for the large lump sum payment you’re about to make?
If your mortgage interest rate is 3.5% and you pay it fully off, then the investment return you get on that lump sum is 3.5%. However, that 3.5% is a lot less than the average 7 to 9% annualized S&P 500 index fund returns you can get by investing those dollars instead of paying down the mortgage. Also consider if you choose to invest in individual stocks, you could be making even more on that lump sum.
One personal anecdote is that I actually withdrew a chunk of money from my brokerage account in May 2020 to pay down some of my mortgage balance since I didn’t think the market could go much higher given COVID cases escalating and that turned out to be an incredibly “pricey” mistake. Had I kept that money in the market, I would have returned 292% since May 2020 vs. the 3.49% that I saved off my mortgage. It’s definitely a decision that I continue to kick myself for.
Here’s the future value of $50k invested at different returns over 10 years:
| 3.5% | 7% | 10% | 292% then 7% |
| $70,529.94 | $98,357.57 | $129,687.12 | $360,338.01 |
10. How much liquidity will you have?
Paying down or paying off a mortgage requires a lot of money generally and it can really eat into your total cash liquidity. If you choose to make that lump sum payment, then be sure to consider how much cash you’ll have left for things like investments, other high ticket priced items (i.e. car, home renovations, etc.), emergency fund, and so on.
You definitely don’t want to be house rich but cash poor and you also should remember that % returns on your portfolio are higher with larger balances.
i.e.
$100 balance with a 10% return = $10 return
$1,000 balance with a 10% return = $100 return
$10,000 balance with a 10% return = $1,000 return
$50,000 balance with a 10% return = $5,000 return
$100,000 balance with a 10% return = $10,000 return
$500,000 balance with a 10% return = $50,000 return
There’s a reason why they say that the rich just get richer. When you have a larger balance, the returns get that much bigger.
Wrapping Up
I know there’s a lot to consider, but remember, it’s a lot of money that can be used for a million other things. My goal in writing this article is to give you some perspective given some of my own personal experiences.
Let me know what you ultimately decide in the comments below!