Pay Your Mortgage Early or Invest?

If you own a home, chances are good you have a mortgage. Making mortgage payments can be a source of frustration for homeowners, some of whom will decide to pay off a mortgage early.

While owning your home free and clear seems attractive, it's important to consider whether paying off your mortgage early is actually a good financial decision. There's lots to consider, including the psychological benefits of being debt-free, along with the consequences to your net worth if you make the choice to pay down your mortgage quickly.

Read on to find out if prepaying your mortgage is the right goal or whether you'd be better off in the long term if you invested instead.

8 reasons you should prepay your mortgage

Prepaying your mortgage is a huge financial decision that requires weighing all the pros and cons. First, let's take a look at why prepayment might be your best bet.

  • Prepaying your mortgage gives you peace of mind: Owning your home free and clear means you won't have to worry about foreclosure if you can't make mortgage payments. You may feel more confident about your overall financial situation if a lender no longer has a claim to your home.
  • You may be more motivated to become debt-free: If you hate being in debt, you may be willing to sacrifice and reduce spending to get your mortgage paid off quickly. If you're not as excited about investing, you may spend extra money instead of budgeting carefully. You're better off paying extra on a mortgage than wasting money on frivolous things.
  • You'll save on interest: You can save a lot of money by prepaying your mortgage. If you have a $300,000, 30-year mortgage with an interest rate of 4.5%, you'd pay around $1,520 monthly. If you increased your monthly payment to $1,820, you'd save almost $80,000 in interest and pay off your loan eight years and six months before the scheduled payoff date.
  • You have a guaranteed return on investment: When you prepay your mortgage, you always save on interest -- so you'll always get a return on investment. You don't have to hope your investments perform well.
  • You'll have more equity in your home: When you pay down your mortgage, you build equity. If you must move, you won't have to worry about your home being worth less than you owe. If you're underwater on your home, you can't sell it unless you bring cash to the table -- at least not without ruining your credit by getting the bank to agree to a short sale.
  • You'll reduce your cost of living: Your monthly mortgage payment is likely your biggest bill. If you eliminate it, you can live on far less. This gives you the flexibility to take a lower-paying job, leave the workforce to raise your kids, or retire earlier since expenses are lower.
  • You can eliminate private mortgage insurance: If you had a down payment of less than 20%, you're probably required to pay private mortgage insurance (PMI). PMI pays the bank if your home is foreclosed on and sells for less than you owe. PMI typically costs around .5% to 1% of the original mortgage loan. On a $300,000 loan, that could total $250 per month or $3,000 per year. If you've paid down your mortgage and your loan balance totals 80% or less of the value of your home, you can ask your lender to get rid of PMI.
  • Home equity gets special protections: In most states, at least some equity in your home is protected if you go bankrupt, have creditor claims against you, or need to qualify for Medicaid to pay for a nursing home. While 401(k)s, IRAs, and other specialized retirement accounts also generally receive some special protections, cash investment accounts don't.

8 reasons you shouldn't prepay your mortgage

Now that you've considered some of the key reasons why prepaying your mortgage could be a good idea, it's important to evaluate the considerable downsides. Here are eight big reasons why paying down your mortgage faster than required may not be the best financial move.

  • There's an opportunity cost: Every dollar devoted to paying extra on your mortgage is $1 you can't use for another financial goal. Since you have a limited amount of money, paying more on a mortgage that has a low interest rate may not make financial sense. This is especially true if you fail to take advantage of other opportunities, such as contributing to a 401(k) with an employer match.
  • Your return on investment is low: While you earn a guaranteed return on investment by prepaying your mortgage, your return on investment is low because mortgage interest rates are low. If your mortgage rate is 4.5%, your rate of return from prepaying your mortgage is just 4.5%. By contrast, the S&P 500 has produced annualized total returns (including dividends) close to 10%, which is significantly higher.
  • Your home is not a liquid asset: Selling your home is time-consuming, difficult, and costly, which makes it hard to get money out of your house if you need it to meet financial needs. There are many more-liquid investments available that can be sold quickly if necessary.
  • You'll lose tax breaks for mortgage interest: Many taxpayers claim a tax deduction for mortgage interest. However, tax reform in 2017 resulted in new limitations on deducting interest for some borrowers while significantly increasing the standard deduction. If you'll be claiming the standard deduction instead of itemizing, losing this deduction won't be a factor for you.
  • You could miss out on tax breaks for retirement savings: If you prepay your mortgage instead of maxing out tax-advantaged savings accounts, you miss out on tax savings. If you paid an extra $5,500 per year toward your mortgage instead of contributing $5,500 to a 401(k) or IRA, you'd miss out on a $1,210 tax break if you're in the 22% tax bracket.
  • You'll still owe on your home: Many people want to prepay their mortgage to own their homes free and clear. However, even if you no longer owe the bank, you still owe property taxes. While your property taxes are likely much lower than annual mortgage payments, you never truly eliminate the risk of losing your home if you can't keep up with obligations.
  • Your assets won't be very diversified: Sinking more of your money into your home means you'll be heavily invested in real estate. If your home declines in value, this will have an outsize impact on your net worth if you don't have money invested in other assets, since extra cash went to bigger mortgage payments.
  • Inflation reduces the savings from prepaying your mortgage: If you have a fixed rate mortgage, your mortgage payments stay the same for the life of the loan. If your monthly payment is $1,500 today, it'll be $1,500 in 25 years. But $1,500 in 25 years is worth the equivalent of just $942 in today's dollars, assuming a 2% inflation rate. Your mortgage effectively costs less over time, and future savings from prepaying interest must be discounted based on inflation. If you take a 30-year $300,000 mortgage today and pay off your loan 8 1/2 years early, the $80,000 you'll save in interest comes more than 21 years in the future, so you effectively save less than $49,000.

How will your net worth be affected by prepaying your mortgage?

While being debt-free is a laudable goal, it's important to look at the big financial picture. You're better off having a small amount of debt and a lot of money than having no debt but no savings either. So, before you decide to prepay your mortgage, think about how this will impact your net worth.

Let's say you have a $300,000, 30-year fixed rate mortgage at a 4.5% interest rate, like the example above. If you pay $1,820 per month instead of $1,520, you pay almost $80,000 less in interest and pay off your loan in 21 years and six months. But, during that time, you've paid an extra $3,600 in mortgage payments each year.

What if you instead invested $3,600 annually for 21 years, putting the money into an IRA or 401(k) and earning 7% on your investments? You'd have $161,514. This is more than double what you'd save in mortgage interest -- so you'd end up with a higher total net worth even though you're still in debt.

After 21 years of payments, you'd owe $134,783 on your $300,000 mortgage if you never made an extra payment. If you decided you really wanted to be debt free, you could take your $161,514, pay off the $134,783 mortgage balance, and have $26,731 left over.

And this doesn't even factor in tax breaks for investing or paying mortgage interest. Making $3,600 investments in a 401(k) or IRA would give you a $792 tax break in the 22% tax bracket. Assuming you got the same break each year, that's $16,632 over 21 years. And, since you'd pay almost $80,000 less in interest, you'd lose around $17,600 in tax savings by not paying that interest if you deducted the full amount and were taxed at 22% each year you claimed the deduction.

What about the fact a mortgage provides a guaranteed return on investment?

One of the best arguments for paying extra on your mortgage is the guaranteed return on investment. However, the return is low compared to what you make by investing. You could invest fairly conservatively and still end up earning a higher rate of return than current mortgage rates -- especially when factoring in tax breaks.

Investing can also provide a guaranteed return from an employer match, if you're eligible. If your employer matched a $3,600 annual 401(k) investment over 21 years, your employer would give you $75,600 in free money, which almost covers the $80,000 in extra interest paid on your mortgage. When you add in tax breaks for investing in a 401(k), you'd end up better off even if your entire 401(k) was kept in cash.

Three things to do before prepaying your mortgage

While the rational thing to do is invest instead of paying off your mortgage early, people aren't always rational and you may want to prepay your mortgage despite the math.

Before you do, there are a few things you absolutely must do first:

  • Take full advantage of an employer match for your 401(k): If you don't invest at least enough money to get your match, you're giving up free money.
  • Pay off high-interest consumer debt: Credit card debt, personal loan debt, and car loan debt charge higher interest than mortgages, and you can't deduct the interest. Pay these debts off first before paying extra on your mortgage. You'll still be working toward becoming debt-free, but will save more in interest and get a better return on your money.
  • Build an emergency fund: Once you've paid extra on your mortgage, getting money back out of your house is difficult and requires you to refinance or take a home equity loan -- both of which carry costs. You don't want money needed for an emergency to be inaccessible when your car breaks down or another financial disaster strikes.

Until you've done these three things, you do not have "extra" money to pay toward your mortgage.

Ways to prepay your mortgage

If you've decided to pay off your mortgage early, you have a few options. You could:

  • Make biweekly mortgage payments: Most people get paid biweekly, but make just one mortgage payment per month. If you pay half a mortgage payment with each paycheck, you'll make 26 half payments, or 13 payments total instead of 12. The downsides are that not all mortgage lenders process biweekly payments and there are sometimes fees to do this.
  • Pay extra with your regular payments: You can simply add extra money to each payment you make. This is easy and flexible because you aren't locked into paying more than the minimum. But, if you're not disciplined enough to voluntarily add extra money with each payment, your plan to pay your mortgage early may not come to fruition.
  • Refinance to a shorter-term loan: If you've taken out a 30-year mortgage and refinance to a 15-year mortgage, you can often lower your interest rate and reduce the time to pay off your loan. The big downside is you're locked into higher payments. If you can't make them, you're at risk of losing your home.

While there are benefits to maintaining flexibility in your payment plan, this flexibility makes it harder to stick to your goals.

Avoiding prepayment penalties

Before you start your prepayment plan, it's important to determine if there's an added cost associated with paying your mortgage early: prepayment penalties. Some lenders impose a penalty for paying off a mortgage before its designated repayment date, to protect their profits on the loan and to prevent buyers from refinancing right away.

Not all mortgages have prepayment penalties, and these penalties work differently from lender to lender. Penalties may be imposed on a sliding scale based on the length of time you've had the mortgage, such as a 3% penalty if you've had the loan for just a year compared with a 2% penalty if you've had the loan for two years or more. Penalties could also be a flat fixed fee for repaying the loan at any time before the designated payoff date; could be equal to a percent of the interest owed; or could equal a percentage of the remaining balance.

The only way to tell if you'll need to pay a prepayment penalty is to review your mortgage loan paperwork or ask your lender. If you'll have to pay a fee to prepay your loan, this is a big argument against prepayment since it makes the "return" on paying off your mortgage even lower.

What decision is right for you?

The right choice on whether to pay off your mortgage early depends on your short- and long-term goals, your risk tolerance, and whether you think you'll be disciplined about investing.

If you're fired up to prepay your mortgage and willing to devote more effort to accomplishing that goal than to investing, you could end up with a higher net worth in the end. Just be sure you understand the opportunity cost and realize you may have been better off investing rather than focusing on becoming debt-free.

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