Last week, we were able to refinance our house for pretty attractive
interest rate, and we face the 30 years of payments ahead again, as we just
started. Conventional wisdom says that lower interest on your loan is better,
especially if the loan is a big as mortgage usually is. Simple calculation will
show you that you are saving tens of thousands, and there is quite unclear if
such low interest will ever be on the real estate market again. May be yes, may
be no. In any case, if the interest drop is significant, reasonable fees you
pay for refinancing are justified.
But refinancing is not the main topic for this post. I would like to
discuss with you if the mortgage should be paid earlier if possible by writing
each month a check which is bigger than your required minimum payment. There is
no straightforward answer, as it all depends on the amount of payment, income,
your ways to spend money, your lifestyle, your retirement plans, and more other
circumstances. But, we will try to bring together some related considerations
for you to decide.
First of all, start viewing on your monthly mortgage bill not only as inevitable
evil, but also as your savings. For most people, a mortgage is the biggest
monthly bill. Although few realize it at first, their mortgage also
represents one of their biggest savings each month. Since a part - a growing
part - of every mortgage payment represents the repayment of principal, part of
that big monthly bill is actually savings. At the end of the typical
30-year mortgage, you'll own your home free and clear. Depending on what
happens to the value of your home over that time, you might find yourself with
quite an asset.
Reasons Why Paying Off the
Mortgage Early Is a Good Idea
There are a lot of people who think that paying off your mortgage early
is a great idea and there is some valid reasoning both financial and
psychological to support this approach. Yes, there is a psychological
aspect of money that differs for each person. Money isn’t all about math for
most individuals. Some are good at separating emotion from money and treating
their finances as a business with little emotional attachment, but that’s not
common in my experience. For some people, eliminating debt is preferred over
maximizing money. For one, less or no debt can reduce stress, which improves
your health.
Here are some of the reasons they give for paying extra:
- Paying less interest on the mortgage: When you pay extra on your
mortgage principal it ends up meaning you’ll shave months or years off of
your mortgage, and you’ll save thousands of dollars in interest. For
example, on a 300,000 dollar mortgage over 30 years, with an interest rate
of 5%, you’ll end up paying over 309,000 in interest. Cut that
to a 15 year mortgage and you’re only paying 143,000 in
interest. Cutting the payment term in half leads to significantly
higher monthly payments, so that is out of question to many consumers,
especially if the mortgage amount is high. However, even small additional
sum you add to your check will cause direct deduction of your principle
leading to the faster mortgage pay rate, and lowering the amount of total
interest you’ll have to send to the mortgage company!
- Less risk, more peace of mind: With less debt on your balance
sheet, you have less risk in your life. You’ll have less to worry
about when your only bills are food, taxes and other necessities. Add
to that having the burden of debt removed from your shoulders. The
psychological benefit of being free of debt isn’t to be underestimated.
And speaking about retirement coming, think if will you be able to pay the
same amount after retirement, as you are paying from your monthly paycheck.
And what if you will get unemployed in your pre-retirement years, when
finding a new good-paid job, or any job will be much more challenging due
to your age?
- More freedom: When you don’t have a mortgage payment when you retired you’ll
have more freedom. Don’t want to take any job at retirement to meet your financial
obligation, do not want to count on your grown-up kids’ financial help –
you don’t have to because your monthly debt obligations are next to
zero. Instead do something you love! You can afford it! You may
be able even to help your kids yourself, if you want to.
- Eliminating debt is a sure thing: While investing in the stock market
isn’t a sure thing -having a paid off house you can live in IS.
- Extra money to save, invest and give: When you have a paid off
mortgage you’ll have a lot more money left over every month that you
can use to save invest and give. Can you imagine how fast your nest egg
would grow if you had no debt obligations - including a mortgage?
- More equity on hand: Paying off your mortgage means you’ll have more equity in your house, which could lead to a bigger reverse mortgage (a way for the 62-and-older crowd to turn their home equity into lump-sum or lifetime income, if needed).
The benefit of having a paid off mortgage can’t be understated. With
no mortgage, and no other debts you’ll be free to pursue things that you enjoy.
You’ll be able to work less doing things you enjoy. You can take the money
you’ve saved in interest and build wealth.
Reasons Why and When You Don’t
Want To Pay the Mortgage Off Early
There are those that say that while it’s a nice idea to pay your mortgage
off early, there are reasons why you shouldn’t.
- Liquidity of your assets and flexibility: One argument against paying off the
mortgage is the idea that putting all your extra cash into your mortgage
means you’re going to have a lot less liquidity in your assets, and if a
situation is to arise where you needed money fast, your money would
be all tied up in your house. This is very important and valid
argument, and the reason why you need to have certain emergency fund, from
which money can be pulled out anytime if needed.
- Higher returns by investing your money: Many people argue that you would
get higher returns on your money if you simply invest it. If you can
get 7-8% on your money, you will end up coming out ahead. On the
other hand, there is risk with investing as well, and there aren’t
guarantees. Ben Stein advises: “Generally
speaking, if you have a very low mortgage rate, it is better to invest the
money than to pay off your mortgage. It's an interesting fact - the rate
of return on your mortgage is the interest you're paying on it. If you
have a 6 percent mortgage and you're paying it off, you're earning 6 percent.
If you can earn more than 6 percent in the stock market, you should
probably put it in the stock market. But, on the other hand, pay it off in
an expeditious way. It's good to have it paid off, or at least mostly paid
off, by retirement time”.
- You miss your employer’s company match to your workplace retirement plan. If, for example, your employer matches you dollar-for-dollar on the first three percent of your contributions to your 401(k) plan, then you’re throwing away free money, if you decided to stop contribution to the plan in favor of making extra mortgage payments. If our employer matches even half that amount, then you’re still passing on a sure-fire 50% return on your money. Opportunities like that don’t come up too often. Take advantage of them when you can.
- You have other
debt that accrues at a higher interest rate than your home loan. It definitely makes no
sense to pay off a mortgage at the moment when you are carrying credit
card debt at a higher interest rate. When you pay off a credit card
with a 15% interest rate, for example, then every dollar of debt you pay
off earns you an instant 15% return. Simple calculation helps to
understand that the high interest loans should be paid first.
- You owe significantly more on your house than it is currently worth. If your mortgage is upside down, the fact is you are more susceptible to foreclosure if you lose your job or suffer some other hardship that prevents you from making your payments.
- Inflation works for you: As inflation goes up by 3-4% annually, by not paying off the
mortgage and paying it over time, you’re essentially paying less for the
same amount of house every year. You pay the same today to live
in the house that you do 30 years from now.
- Tax deduction: You can deduct the interest you pay on your mortgage, on your taxes. However, keep in mind that the true tax benefit is limited to the extent that your itemized deductions exceed the standard deduction, which in 2010 is $5,700 for single taxpayers and $11,400 for married taxpayers; those age 65 or older get an additional $1,400 (if single) or $1,100 (if married) deduction each. Also, mortgage payments progressively consist of more principal and less interest. Thus, the amount you can deduct declines each year. The bottom line: The mortgage-interest deduction can be valuable, but don’t overestimate it.
Summary
While there are multiple
considerations as whether pay or not the mortgage early, I personally adapted
several rules, which work for me and my family:
- The mortgage should be paid in full by the retirement age, or even earlier for at least couple of years.
- Do not put all eggs in one basket: try to get multiple assets in your retirement portfolio, and closer you get to the retirement age, less risky it should be.
- The highest interest loans should be paid first.
Sources
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