Should I Pay Off My Mortgage?

August 15, 2022  | By David Lowe

Debt can be a complex and emotional topic. That is true even for mortgages and other “good debt” (a term sometimes used for money owed on an asset that is likely to increase in value).

For many Americans, the mortgage on the personal residence is the largest liability on the net worth statement. That’s not necessarily a bad thing – especially if you can afford the monthly payments, the house appreciates over time and you love living there! After all, homes help form many of life’s greatest memories and can strengthen some of the most treasured relationships.

A home loan is a big financial commitment, though, and it affects many other financial factors. As a result, it is important to think carefully about several issues before deciding whether to pay off a mortgage early.

Consider other debts

It can feel like a major relief to pay off the mortgage on a personal residence. In some cases, retiring the mortgage early may be the best choice. On the other hand, those who have other debts may benefit more from paying off those loans first.

For example, consider two other common sources of debt: credit cards and student loans. Imagine a family with the following liabilities and associated interest rates:
$300,000 mortgage at 3.5% (fixed rate – more on adjustable-rate mortgages later)
$100,000 of student loans at 7%
$30,000 on credit cards @ 18%

Even though the student loan and credit card balances are much lower than the unpaid mortgage principal, the interest rates are higher. In other words, every dollar borrowed through credit cards or student loans costs more (in long-term interest) than the mortgage does. For that reason, the family could save more money by paying off the credit cards and student loans than by retiring the mortgage note early.

Refinancing high-interest-rate debt can help, too. That’s true as long as the cost of refinancing is less than the total savings that will result from a lower interest rate and/or a shorter loan term.

Note: based on recent interest rate increases, refinancing a fixed-rate mortgage probably is not the best option at this time. The St. Louis Fed reported the average U.S. rate for a 30-year, fixed-rate mortgage was 4.99% as of Aug. 4, 2022. That was higher than rates have been since February 2011. Although rates have dropped a bit in the last month or so, on June 23, the U.S. average hit 5.81%. The key point: Those who borrowed money to buy a house between 2011 and the end of 2021 probably cannot beat their existing fixed interest rate (at least based on today’s market conditions).

Adjustable-rate mortgages

Refinancing or early payoff could be beneficial, though, for those who have adjustable-rate mortgages. These loans have an initial period in which the interest rate does not change. (Five years is common, according to Freddie Mac.) After that, the rate adjusts periodically, based on market factors and the terms of the loan.

Although there are limits to how much an adjustable-rate mortgage interest rate can increase, even a few extra percentage points can mean a much higher monthly payment. That can strain a budget and make it difficult to save for important long-term goals. If a rate adjustment is coming – particularly in times of rising interest rates, as seen in 2022 – retiring the note or refinancing to a fixed-rate loan could save money in the long term.

Make sure to include fees or penalties in the analysis. Prepayment penalties on adjustable-rate mortgages can add up to several thousand dollars, according to Freddie Mac.

Maintain enough savings

When thinking about paying off a mortgage early, it is important to identify what funds to use for the prepayment. Those assets should be liquid, meaning easy to use without incurring a penalty. Checking, savings or money market accounts – often called “cash” accounts – are good choices.

Although cash accounts can provide the funds for a mortgage payoff, it’s important not to deplete cash reserves too much. A wise general guideline is to keep an “emergency fund” saved for unforeseen financial disruptions, such as a disability, job loss, expensive medical procedure or insurance deductible (i.e. roof damage from a storm). Two-income families typically need to save an amount equal to three months of normal living expenses. Single people or one-income households may need to keep as much as six months’ worth of reserves.

The emergency reserve is essential, both financially and for mental well-being. If an unexpected major expense occurs, a person without a big enough cash cushion might have to sell investments at a loss to generate funds. That is a serious threat to long-term wealth accumulation. Also, stress multiplies quickly when there is not enough money to cover pressing needs. Life is too short to worry about money! Keep a sufficient emergency reserve so you can focus your attention on what’s most important.

Beyond maintaining an emergency reserve, it also helps to earmark savings for specific one-time needs expected in the next one to two years. Think of trips, weddings, vehicle purchases or the less fun (but still essential) expenses that happen at least annually – property tax payments, an insurance policy premium, back-to-school supplies, etc. Paying off a mortgage is great, but ask yourself if it’s worth it if you’ll have to rob too much from your savings. Do you want to be mortgage-free a year or two early if it means skipping the Rocky Mountain hiking trip you planned for next year?

Sometimes, though, it’s not a big concern to dip into reserves for a short time to pay off a mortgage. If the savings help the budget enough, it may not take long to bump the emergency reserve or other savings accounts back up to the target level.

For example, say the principal and interest on a mortgage total $1,000 a month. Assume also that paying off the mortgage requires dropping a savings account balance $4,000 lower than you would like. Maybe the savings account is designed for a goal that still is a bit away – such as a 25th wedding anniversary trip a year from now. No problem! Assuming other expense patterns stay the same, the savings account will be replenished in just four months, leaving plenty of time (and money) to get ready for the special occasion.

Investing tradeoffs

Another way to think about prepaying a mortgage is to consider what economists call “opportunity cost.” An opportunity cost is what a person decides not to pursue by choosing to allocate resources, such as money or time, to something else.

One tradeoff when prepaying a home loan is the potential investment return a person could have gotten from the dollars that instead went toward mortgage payments. Of course, as financial planners say (or should say) often, there is no guarantee of any particular return on investment. Nevertheless, long-term statistics paint a good picture.

The S&P 500, which includes the largest U.S. public companies, has recorded an average return of 10.7% in the past 65 years, according to Business Insider. Adjusting for inflation (and with an even longer-term data set), global management consulting firm McKinsey & Company reported that since about 1800, real returns on the stock market have been about 6.5%-7% per year, on average.

To look at these numbers in a simplified way, say you have a fixed-rate mortgage at 4%. Every dollar spent on mortgage prepayment “earns” 4% (by decreasing total interest paid). In contrast, that same dollar could have earned – again, there are no guarantees in investing – 6.5% or more in a diversified portfolio held for the long term.

With that said, it’s essential to consider your overall goals, including peace of mind, values and risk tolerance. Maybe being debt-free is extremely important to you. Perhaps you have plenty of funds set aside for other goals, leaving extra money available to pay off the mortgage. Maybe you simply like to limit investment risk – or you know that you will feel too stressed if you risk more in the market while still carrying debt. In all those cases, paying off the mortgage could be the best choice.

House costs that continue after the mortgage is gone

If you decide to pay off your mortgage, celebrate your success! Enjoy the extra flexibility you may find in your budget.

Remember that not all your house-related costs will vanish, though. Homeowners’ insurance and property taxes may have been included in your monthly mortgage bill automatically, as part of the escrow payment. Once your mortgage is gone, it is essential to maintain adequate homeowners’ coverage to pay for repairing or replacing your house if it sustains severe damage. After all, your home may be one of your biggest assets.

Property taxes also will continue annually. Account for it and for homeowners’ insurance by including it in your budget.

You can divide the expected annual cost by 12 and add that amount to your savings each month. Or, if you receive non-monthly income (such as bonuses, investment income or Required Minimum Distributions from retirement accounts), you can draw from those to top off your savings account quarterly, semi-annually or annually. Some people prefer to keep all their planned non-monthly expenditures – from taxes and insurance to trips and other fun things – in one all-purpose savings account. Others use separate accounts for tax or real estate expenses. Whichever method you prefer, just make sure to plan for those costs so they don’t sneak up on you once the mortgage is paid off.

We wish you happiness in your home – however you choose to pay for the house!