Whether or not to pay down a mortgage early has always been a widely debated financial planning topic. The truth is, this decision is not always clear-cut and should be reviewed on a regular basis. Both sides of the issue bring valid arguments. We feel that paying down your mortgage early needs to be thought through, without exception.
In this article, I’d like to share some of the key reasons why clients decide to pay down their mortgage early, and why clients decide to maintain their mortgage and put excess cash flow elsewhere. If this is a decision that you are considering, we invite you to connect with our team for a personalized analysis.
Reasons to NOT Pay Your Mortgage off Early
By and large, the greatest argument for keeping your mortgage is the opportunity cost of making extra payments each month. This is money that could be directed elsewhere, like into savings or investment accounts.
Here is the “spreadsheet” answer: if my investments return 6% while my mortgage rate is 3.5%, that’s a net gain of 2.5%. This means that more of my excess cash flow should go toward my investments (gaining me 6%), rather than toward paying off my mortgage early (saving me 3.5%). While the spreadsheet answer is appealing, there’s a lot of assumptions that go along with this concept that don’t always pan out (as 2020 has taught us). Your investment return is never guaranteed, and in our experience, the savings from not paying down your mortgage are often spent rather than diligently being invested.
One way to ensure that the excess cash is invested is to increase contributions to your retirement accounts (401k, IRA, Roth, or other retirement vehicles). Since these have the longest runway to grow tax-deferred or tax-free, they should often be one of the first accounts to add additional savings.
Keeping your mortgage may also allow you better flexibility to build and maintain cash reserves in the event of an emergency. See my colleague Adam Rudolph’s blog here on the importance of building an emergency fund. Conversely, if you use funds to pay down your mortgage and then want that cash back for any reason, you’d need to put a new mortgage on your property (or obtain a home equity line of credit), which involves some complexity and administrative hassles.
Another reason to hold onto your mortgage is the current interest rate environment. Recently, the Wall Street Journal reported 30-year mortgage rates fell to their lowest level ever to a mere 2.98%.1 This incentivizes people to keep their mortgage or refinance at a lower rate and redirect their cash savings to save or spend elsewhere.
It’s worth mentioning that there is a tax break for mortgage interest paid, although it’s not as common as it once was since many people do not itemize their tax returns anymore. If you do itemize, you’re able to reduce your taxable income by the amount of money that you’ve paid in mortgage interest during the year. However, there are limitations on the amount you can deduct. We encourage you to reach out to your accountant to find out if you are eligible and if it makes sense to itemize deductions to capture this benefit.
Reasons to Pay Your Mortgage off Early
Alternatively, a reason to pay down your mortgage early is the emotional cost of having a mortgage. Some people are uncomfortable with any debt …and that’s perfectly fine. You can’t put a price (or apply spreadsheet math!) on the removal of financial stress and complexity in managing short-term and long-term finances.
Let’s take a look at the following scenario to illustrate this point.
Say a couple with two children has a $300,000 mortgage with a 3.5% interest rate. This couple has a $6,000,000 portfolio and is making close to $1,000,000 a year from their salaries and investments. Considering their net worth and annual income, it may make sense to pay off their home mortgage early. They take some complexity off their plate, and they do this in a way that will not impact their long-term financial plan.
By paying off their mortgage, they also took advantage of the investment component associated with early mortgage payment. In making their payment, they effectively received a guaranteed investment returning 3.5% annually for the remainder of their mortgage term. In other words, they avoided the interest payment that would be charged on their principal balance. This results in more dollars in the long run by avoiding future interest payments.
Perhaps more importantly, they reduced the complexity of their financial situation by removing a relatively modest liability.
The Choice Is Yours
The choice is yours to keep or pay down/off your mortgage, but you have to think it through and look at the decision from different perspectives. This decision depends on your financial situation at any moment in time– do you have the free cash flow if an emergency or an investment opportunity should arise? Can you afford to make that extra payment and maintain your current standard of living? And importantly, as discussed above, it may also depend on your personal feelings toward debt at any moment.
There will always be multiple choices to make related to your mortgage. Our advisors are here to provide guidance and see what makes the most sense with your unique situation.