Living debt-free sounds great, and depending on where you are in life it may actually be attainable. But even if you can pay off your mortgage early, should you?
Although it may be tempting, first consider the opportunity cost of paying off your mortgage early at the expense of other goals or investment options, as well as the impact to your tax situation.
Opportunity cost. By paying off your mortgage early, you’ll save on the additional interest expense that would have been incurred in your regular payments. This savings can be significant, and will increase with the prepayment amount. However, by directing excess cash towards paying down a mortgage, those funds are no longer available for investment. The lower your interest rate, the less you stand to benefit through early retirement of debt.
How can you decide whether it is best to invest excess cash or pay off your mortgage early? Consider the following example:
Suppose the stated interest rate on your mortgage is 4 percent and you are in the 28 percent federal income tax bracket. Your after-tax mortgage rate is roughly 2.9 percent, perhaps lower if you can also deduct the mortgage interest on your state income tax return. For many investors, investment portfolios are constructed using a risk tolerance that carries a much higher annualized expected investment return than 2.9 percent.
For some, the “guaranteed” 2.9 percent savings is more attractive than a higher expected market return, subject to greater volatility and risk. For those with a much higher after-tax mortgage rate, paying off a mortgage early likely becomes a more attractive option.
Here are some other considerations:
Taxes. For many, the ability to deduct mortgage interest is a key component to their tax strategy. Consider whether you will still be able to itemize deductions without mortgage interest.
Investing. Realistically consider whether you’ll invest the cash that would have been directed towards paying down your mortgage or spend it. Consider direct deposits into your brokerage account or increasing your monthly 401(k) contribution in an effort to “set it and forget it.”
Other needs. Aside from the ability to invest excess cash, are there any other more pressing goals on the horizon? Look at your whole financial situation including student loans, credit card debt and whether you have adequate emergency reserves.
Life stage. The decision to pay down a mortgage will vary depending on yourlife stage, risk tolerance and time horizon. If you’re nearing retirement you may have a more conservative asset allocation, and investing the excess cash in the market may mean taking on unnecessary risk. Being debt-free may also become more important later in life.
Time horizon. If you are planning to stay in your home for the long term, it makes more sense to consider overpaying your mortgage than if you don’t anticipate ever paying off the note.
As you weigh the options, set realistic expectations and ensure the proper plan is in place to achieve your objectives. Discuss the decision with your financial adviser and tax professional before committing to a strategy. As with all financial goals, it pays to be flexible. If you’re still unsure which direction is best or whether you have adequate reserves, think about opening a dedicated savings account for your excess cash flows and revisit the decision in three to six months. By separating the funds, you will be less likely to spend it on daily expenses while you consider the options.
Kristin McFarland is a blogger for The Smarter Investor and director of strategic partnerships at Darrow Wealth Management, an SEC registered investment adviser in Massachusetts. The material contained in her articles is for general information only and should not be construed as the rendering of personalized investment, legal, accounting or tax advice. You can connect with her on LinkedIn and follow her on Twitter.