With the average mortgage payment being about $2,000, you might dream of no longer having to hand your lender a big chunk of your income each month. And then you’ve got the hundreds of thousands of interest you might pay by the time everything’s over.
But before you start throwing more money at your mortgage, don’t assume that paying it off early is a great money move. The reality can be much different. Not only could you miss out on earning more money elsewhere, but you might not get the relief you expected. Let’s look at the tradeoffs so you can make a decision about your mortgage that you won’t regret.
You Might Miss More Than You Save
Sure, paying off your mortgage means paying less interest. But what about other things you could have done with the extra money? Depending on the mortgage rate, investing your extra money can look smarter once you look at the numbers.
Maybe you lucked out with a 3% mortgage rate in 2021 and think you can get a 7% return on some stocks. That 4% difference (before any taxes) might tempt you to keep your mortgage payment and invest extra cash. Even though I must warn that investment returns aren’t a guarantee, you might be OK taking your chances.
That’s why I always recommend running the numbers for both options yourself (such as using this investment calculator) or working with a financial advisor or tax professional.
It Might Be Less Relief Than You Think
You’d think dropping the mortgage payment would make budgeting easier, and that’s not a lie. But don’t forget that the extra cash you used would be hard to access and tied up in your home. Rather than taking money out of the bank, you’d need to make the tough (and often expensive) decision to sell it or borrow against its equity.
I recommend thinking about what you’d do if something happened and you needed money for a medical bill or something else. If you get desperate, you might look at credit cards, personal loans, or home equity loans. What’s bad is those often have even higher interest rates than mortgages. Basically, you might put yourself back in a more expensive place than you started.
And if you decide to get a HELOC or home equity loan, your home will be on the line and tied to the new debt. That’s considering you even make it through the lengthy application process and have good credit, a stable income, and low enough other debt to get approved. Having the extra cash in the bank would have made things much easier.
Your Tax Bill Could Go Up
Paying mortgage interest looks expensive on paper, but it may be exaggerated if you’re not looking at the actual cost after tax savings.
Depending on when you got your home, the IRS lets you deduct interest on either up to $750,000 or $1 million of your mortgage. Of course, there’s a catch: you have to itemize, which most taxpayers don’t do because they save more with the easier standard deduction.
If you make a lot of cash and usually owe Uncle Sam a large sum, though, not being able to deduct your mortgage interest can make things even worse. That’s because the deduction reduces your taxable yearly income, along with other itemized deductions you claim for things like your property tax bill and donations to your favorite charity.
With $12,000 in mortgage interest paid each year, that could look like a $1,200 to $4,440 lost deduction, depending on which tax bracket you’re in (10% to 37%). I recommend checking your tax return and asking a tax preparer or CPA how much your tax bill could go up if your mortgage is no longer in the picture.
Your Lender Might Penalize You
While it might be surprising, paying off your mortgage can actually make your lender financially punish you. That’s due to a potential prepayment penalty that helps compensate your lender for lost interest payments, which makes sense for them but isn’t good news for borrowers.
You’ll usually pay this fee if you have a fixed-rate conventional mortgage, which is very popular, and you’re paying it off during the first few years. That’s when the biggest portion of each mortgage payment goes toward interest.
The Dodd-Frank Act lets lenders charge you up to 2% of your remaining mortgage balance in the first year and 1% in the second year. You’ll need to check your mortgage documents, as the calculation used and the conditions can vary. Yours might have a sliding scale or charge you some flat amount (either a fee or months of interest).
Either way, the penalty can easily cost you thousands of bucks (like $5,000 with a $250,000 mortgage balance), making the total savings less impressive. Know that the IRS treats the prepayment penalty as deductible mortgage interest. This is helpful, but in my experience, it usually doesn’t offset the full fee.
Is Paying Off Your Mortgage Early Ever Wise?
As you’ve seen, early mortgage payoff often isn’t the smart decision you think it is. With that said, there are some situations in which you might proceed with caution.
If you got unlucky with your mortgage rate (I’d say, 7% or more), the potential gains from investing versus paying off your loan can become less impressive. I’d consider paying off my mortgage more aggressively in that situation since the guaranteed returns look better than a hypothetical similar return on the market. It would also be wise to funnel your former mortgage payments to investments afterward.
Other goals can also make you rethink things. Are you retiring soon and don’t want a $2,000 mortgage payment hanging over your head when you’re supposed to relax and enjoy life? If paying it off doesn’t mean losing a lot of your retirement savings, you might go ahead. The same is true if you don’t really have other goals for your extra money. Still, I’d recommend putting spare income toward high-interest debts and investments whenever you can.
And, if your mortgage is ruining your life and peace, the benefits of keeping it might go out the window. Just make sure you have the money and a stable enough financial situation to pull it off.
Proceed Carefully To Avoid Regrets
For many people, I think it doesn’t make sense to pay off your mortgage early, at least not in the extreme way. Remember that you could still save on interest if you paid a little extra each month and put the rest of your cash toward investments and high-interest credit card debt. Don’t make the mistake of thinking you have to choose between saving on interest and earning money.
At the same time, you’re going to have to look at your whole situation. The last thing you want to do is make a money move that throws you off track for something else or leaves you out of luck in an emergency. Making a big decision about paying off your mortgage isn’t easy, so I suggest finding a professional who can run your numbers and help you decide how to proceed.
Frequently Asked Questions
How do you make extra mortgage payments?
You could send in a large lump sum, add extra to your regular payments, or make extra mortgage payments whenever you can. Be sure to tell your lender to put the extra funds toward the mortgage principal so that you really do save on interest.
When should you refinance rather than pay off your mortgage early?
Refinancing is something to consider if you can get a lower mortgage rate that saves you in interest and gives you a more budget-friendly payment. That’s because you could use the spare cash for investments or other goals. But watch out for expensive closing costs.
What’s different if you pay off a 15-year mortgage early?
You’ll often deal with the same risks with one key difference. Shorter mortgages tend to have lower interest rates, so you’re paying less overall and building equity faster. They also have higher payments, though, so paying even more might be less appealing than investing.
Should you pay off your mortgage before investing?
It’s often smart to invest and pay down your mortgage at the same time rather than go to the extreme one way or the other. Still, your financial situation and goals matter. If your mortgage rate is too high or you’re going to retire soon, you might find paying off your mortgage early more important right now than investing.
