Being debt-free is a good goal to have, but you may want to think twice before prematurely paying off your mortgage. With interest rates near record lows, homeowners might be better off putting that money to work for them elsewhere.
Debt: Good, bad, and uglyI like to separate debts into three categories: good, bad, and ugly. You should prioritize them accordingly when coming up with your own "get out of debt" plan.
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Ugly debts are those with extremely high interest rates and those on things you don't really need. By far the biggest culprit in this category is credit card debt, which is the third-highest form of debt in the United States, behind mortgages and student loans. Credit card debt generally has a high interest rate, and should be eliminated before you do anything else with your excess cash, including investing.
Bad debt includes debt with decent interest rates on things that help your life, especially those debts that buy items that will lose value over time. An auto loan is a good example here -- a car helps you get to work and do all of the other things you have to do, and generally comes with a reasonably low interest rate. However, the car will lose value over time. A $30,000 car loan at 5% interest for 60 months will ultimately cost you about $32,300. Meanwhile, you'll be lucky if the car is still worth $15,000 after five years. After credit card debt, this should be the next to go.
Finally, good debt has a low interest rate and results from acquiring an asset that can increase in value over time; for most people this means a mortgage. For starters, real estate has historically risen in value by about 3% to 4% per year. So, even though a mortgage will cost you money, over time the value of the home will rise to offset that.
You can actually make money by keeping your mortgageThere is another reason to think twice before paying off your mortgage. Mortgage rates are generally so low (especially now) that you are better off putting your money to work somewhere else. For example, let's say you take out a $200,000 mortgage at 4% interest for 30 years, and that you happen to inherit exactly that much money shortly after. Should you pay it off?
Well, over the 30-year life of that mortgage, you can expect to pay back about $344,000 in principal and interest. So, at first glance, it might seem a no-brainer to simply pay $200,000 now and be done with it.
However, it's relatively easy to construct a low-risk investment portfolio that will produce annual returns of 5% through corporate bonds, blue-chip dividend stocks, and other investment vehicles. If you invest $200,000 at 5% growth, it would be worth more than $864,000 after 30 years. So, even though you'll have made $344,000 in mortgage payments, you still come out $520,000 ahead. That's no small chunk of change!
A final thoughtIf being debt free is an important goal in your life, paying off your home isn't a bad idea, especially if it will give you peace of mind and make you feel better about your financial situation.
However, there is such a thing as "good debt," and a mortgage is as good as any. As long as you borrow within your means, there is no compelling financial reason to accelerate your mortgage repayment.
The article Is Paying Off Your Mortgage Early a Good Idea? originally appeared on Fool.com.
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