A 2006 study by the University of Michigan shows that 40% of households make the incorrect decision to pay off their mortgages early. That means many homeowners pay their mortgages off early, when there was a better financial alternative.
When Early Mortgage Payoff Isn’t Smart
Some loans include a mortgage prepayment penalty if you pay off your mortgage too soon. This penalty is typically assessed if you pay over a certain amount of money toward your mortgage in a single year. Some mortgages penalize you if you pay more than a certain percentage of your scheduled payments in a year. Others penalize you if you pay even a single dollar over your scheduled mortgage payments. Before you start sending extra mortgage payments, check your loan documents to make sure there is no penalty.
If you have any credit card debt, you should focus on paying it off before considering paying off your mortgage early. Credit card debt is often more expensive to carry than a mortgage because it has a higher interest rate. In the grand scheme of things, you’re not saving much money if you pay off you lower-interest rate mortgage and leave a balance on higher interest rate debt.
Paying off your mortgage early might also leave you without a tax benefit if you’re in a higher tax bracket and you owe more than 15 years on your mortgage. You might talk with your tax preparer about the tax implications of paying off your mortgage early.
It’s important that you don’t skip out on other, smarter financial decisions, just to pay off your mortgage. For example, if your employer offers a match on your 401k investments, you should max out the investment. Otherwise, you’re giving up free money. You also shouldn’t give up paying insurance in lieu of mortgage prepayment. You need life insurance to cover your mortgage in
case of your death, health insurance to offset the cost of expensive medical bills, and disability insurance to supplement your income if you suddenly become disabled.
Early Mortgage Payoff vs. Investing
Before you pay off your mortgage you should weigh the alternatives. What would happen if, rather than send an extra mortgage payment to the mortgage lender, you instead invested the money every month. If the investment has a higher interest rate than your mortgage, you would ultimately earn more money on the investment than you would have saved on the mortgage. On the other hand, if your mortgage has a higher interest rate than investments, it’s better to pay off the mortgage.
For example, let’s say you have 15 years left on a $200,000 mortgage at 6.25%. You decide to put an extra $600 a month toward your mortgage. You would end up saving $36,574 in interest and your mortgage would be paid off in just over 8 years. Let’s say at that point you start investing your entire mortgage payment including the extra $600 for the 6 years you had left on the mortgage. At the end of 6 years, you would have $173,000 from your investment.
Consider the alternative of not paying your mortgage off, but investing the extra $600 every month at 8% for 15 years. You would end up with $209,000. That’s $36,000 more than you would have earned if you’d paid your mortgage off early.