Rock-bottom interest rates and soaring home values have housing on a lot of peoples’ minds. The question, “should I pay off my mortgage?” seems to creep into the minds of old and young homeowners alike.
Since mortgages are not created equal and financial plans are customized to individuals’ situations, the answer to whether it makes sense to pay off a mortgage is going to be different for everyone. In order to determine whether paying off your mortgage makes sense for you, we will examine some common justifications for this course of action while also highlighting considerations for each scenario.
Paying off my mortgage early will enable me to retire comfortably.
Consideration: Being debt-free can boost any retirement plan, but retirees still need a nest egg to pay other bills.
Entering retirement debt-free is an admirable goal, but paying off debt early does not guarantee an idyllic retirement. It is possible to live your dream retirement while still paying down a mortgage, just as it is possible to have a cash-strapped retirement while being debt-free.
Instead of focusing solely on becoming debt-free by retirement, it’s important to take a step back and ensure that you are on track to have enough cash and investments saved to cover all your other obligations in addition to unexpected expenses that will inevitably arise over the course of your retirement. A financial planner can help with this assessment. Once you’ve determined that you are reasonably on track to cover the totality of your retirement lifestyle, you can proceed with confidence in paying off your mortgage.
Keep in mind that your retirement expenses could be on par with (or in excess of) your pre-retirement expenses even without a mortgage payment. It’s not unusual for retirees to live more lavishly under the pretense they can afford additional discretionary spending since they no longer have a mortgage. This concept – “lifestyle creep” – can pull retirees into a vicious cycle of excessive spending and can jeopardize retirement savings.
Ultimately, it’s important to not sacrifice your long-term financial well-being for the immediate satisfaction of being debt-free.
The stock market is so volatile! Paying off my mortgage will provide a better return on my money.
Consideration: With higher risk comes higher reward; there are trade-offs of paying down debt versus investing the same amount of dollars in the stock market.
One additional dollar applied against your mortgage is one less dollar that could be invested in your 401(k), IRA, or other investment account. If you are reviewing your budget and trying to decide how to allocate extra funds, it’s best to apply the basic economic principle of opportunity cost.
Opportunity cost is the potential benefit you forego by choosing one option over another. In this case, your opportunity cost is the difference between the potential return on investment. With a mortgage, your return is limited to the interest rate. In other words, when you pay off your mortgage your return on investment is equivalent to the interest you no longer have to pay the bank. Mortgage rates vary based on your personal situation, but on average, the current rate on a 30-year fixed mortgage is approximately 3%. Conversely, returns for the stock market (as measured by the S&P 500 Index) averaged approximately 8% per year over the last 94 years. Based on this assessment, it’s clear that investing can generally yield a higher average return.
In general, the younger you are, the more time you have to enjoy the benefits of compounding returns, which is the ability of your money to increase exponentially over time. This typically means that a young investor will benefit more from investing their surplus cash flow instead of paying down a mortgage.
My house is my largest asset, and it will only keep increasing in value.
Consideration: “Liquidity” is how quickly an asset can be converted to cash. Consider the liquidity (or lack thereof) of your home.
Home values don’t only trend upwards. Though the housing market has been red-hot over the past few years, 2008 is still fresh in many minds. There’s always a chance that your home could rapidly decline in value, which could complicate your retirement plan in an instant if you were planning to use your home as a source of retirement cash flow.
Compared to other assets such as money market accounts, stocks, and mutual funds – which can be sold and converted to cash within a few days – it takes considerable time and effort to turn real estate into cash. If you’ve ever sold a home, you know how painful (and slow) a process it can be. Home equity lines of credit – often seen as a source of quick and easy cash – present liquidity challenges as well: it can take weeks or months for your application to be approved, which means there is a significant waiting period before you can turn your equity into cash.
While it is fair to count your home as an asset, be careful to not view it the same as more liquid alternatives that can be quickly accessed in a bind.
I hate paying interest! With my mortgage I’m just throwing money down the drain.
Consideration: You might be able to take a tax deduction for mortgage interest – meaning your payments are not totally wasted dollars.
Each year, mortgage companies send a Form 1098 to report your year-end mortgage balance, total interest paid, and real estate taxes paid. Taxpayers who itemize deductions are generally allowed to write-off, or deduct, however much mortgage interest they paid during the year. Depending on your interest rate and how far into the loan you are, this could equate to thousands of dollars in tax write-offs.
For example, if you are in the 22% tax bracket (and itemize deductions), paying $5,000 in mortgage interest equates to $1,100 in federal tax savings ($5,000 x 22%).
Most mortgages are amortizing loans, which means a higher percentage of your payment goes towards interest early on while you slowly and steadily pay down the principal (the amount you owe the bank). Individuals in the early stages of home ownership might feel like they’re fighting an uphill battle by trying to pay off their mortgage early. It can be demoralizing to make extra payments on your mortgage only to see the outstanding principal balance barely decrease.
The Bottom Line
Whether you should pay off your mortgage early or not depends on a variety of factors. A general rule of thumb is the younger you are, the more “bang for your buck” you get by investing as opposed to paying down low-interest debt like a mortgage. For older homeowners, consider the backdrop of your overall financial plan: are you reasonably on track to support a decades-long retirement? If so, you may have more wiggle room in your budget to make extra mortgage payments. If not, consider the opportunity cost of paying down a mortgage versus investing for a potentially greater return. Ultimately, it is important to consult with a financial professional to help review your personal situation to ensure you can meet your financial goals for retirement.
If you have any questions, please reach out to our team here at Taylor Hoffman!
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