If you have extra funds left over after your expenses are paid each month, weigh your options carefully before deciding whether to pay extra on your mortgage or invest more in the market.
- In addition to weighing interest rates vs potential returns on investments, consider how near or far you are from retirement and how much time you have available to benefit from potential market returns.
- Make sure you have cash in savings or a home equity line of credit to deal with unexpected expenses.
What to consider if you’re thinking of paying off your mortgage early
Say you have extra funds after your expenses are paid each month. Should you increase your mortgage payments and save on interest? Or invest the extra cash in the hopes of accruing interest? It’s a decision that should be weighed carefully.
Two distinct components: Emotional and rational
“The question of whether to carry a mortgage into retirement has two distinct components: emotional and rational,” says Mike Greene, Senior Vice President of Financial Advice at Ameriprise. “A home represents so much more than the return you might get from it — it’s where you raise your family and create memories.”
On a purely rational level, a home is an investment not unlike buying a stock: You take out a loan, buy a home, make payments and hope it appreciates in value. But, as we were reminded in 2008, stocks don’t always go up and neither do home values.
Setting emotions (and market unpredictability) aside, here are some key factors to consider if you’re thinking of paying off your mortgage early.
Weigh the “interest vs. invest” equation carefully
“The return on paying off your mortgage early — either through regular extra monthly payments or by occasional lump sums — is the amount of money that would have been paid in interest,” Greene says. “What you don’t know is the return you would have gotten on the money had it not been used to pay off the mortgage.”
Consider how close you are to retirement
That question often proves to be an irresistible siren call for homeowners. “Many people calculate based on their risk tolerance and portfolio allocation, assuming they can earn more back from the market than they pay out in mortgage interest and save with tax deductions — particularly now that we have historically low-interest rates,” Greene says.
- Interest rates aren’t always a make-or-break factor; when mortgage interest rates are low, expected returns in the stock market can also be lower.
- Younger investors who opt to invest rather than putting their extra funds toward their mortgage have more time to benefit from potential market returns.
- People nearing retirement often reduce their exposure to risk by investing in fixed-income rather than equity products.
Factor in the possibility of unexpected events
In theory, not tapping into savings to increase mortgage payments improves a homeowner’s cash flow, which enables them to better deal with unexpected expenses. But if those expenses are severe enough to drain the family’s cash reserves, the family gets hit with a double whammy: Savings are depleted and their home could be at risk because they can’t afford mortgage payments.
“What if a significant and costly health event renders you unable to make mortgage payments and puts you at risk for foreclosure?” Greene asks. If the mortgage had been paid off before catastrophe struck, watching unpaid bills stack up would be stressful — but less traumatic than facing the possibility of losing your home.
“If you’ve paid off your mortgage, I strongly recommend setting up a home equity line of credit as soon as possible in case you need liquidity down the road,” Greene advises. “In an emergency, you could access the equity in your home.”
“Before even considering paying off your mortgage, pay off other higher-interest loans and make sure to fund your retirement accounts in order to maintain your lifestyle in the future.”
Get a second opinion
With so many factors at play, even the savviest of investors would be wise to consult with an expert before making any mortgage-related decisions. “I would include two professionals: your financial advisor and a tax professional,” Greene says.
- An advisor can acknowledge the emotion attached to your decision while helping you explore other scenarios based on income, savings, lifestyle, expenses and risk tolerance.
- Bringing a tax professional into the discussion is invaluable for helping to understand how retaining or paying off your mortgage will affect your tax situation, a component that is often more impactful than homeowners may realize.