With the recent housing crisis and record-level foreclosures still fresh on our minds, you may be tempted to pay off your mortgage early. Mike Blehar, managing director and principal at Fort Pitt Capital Group, a fee-only investment management firm in Pittsburgh, says he often hears this refrain from clients who only have a few years left on their mortgage. "That's one of the most common attitudes that we [hear]," he explains. "People will say, 'Mike, I just don't like debt.'"
Although early-payoff penalties on residential mortgages have mostly disappeared and the Great Recession taught homeowners to avoid debt, it doesn't always make sense to eliminate your mortgage entirely. Here are five factors to consider before prepaying your mortgage:
1. Your interest rate. Blehar points out that if you had a mortgage with a 4 percent interest rate, the net borrowing cost could be as low as 3 percent after factoring in the home-mortgage interest deduction on your taxes. However, if your mortgage is mostly paid off, the tax deduction is less attractive since at that point, you're mostly paying down principle.
In some cases, Blehar advises clients to refinance rather than pay off their mortgage ahead of schedule. "You can refinance for dirt-cheap rates, and that typically will make sense for people carrying mortgages at high interest rates," he explains.
2. Your investment options. Consider where the money will be coming from and whether you might get a higher return by using it in other ways. "If you take $50,000 out of your portfolio, you're likely going to have to pay taxes on it, and that $50,000 can potentially earn more than 3 percent per year," says Blehar. "The math says that extra payment should go into your investment account." If you're skittish about investing the money, Blehar says prepaying the mortgage may be a better option than earning less interest in a savings account.
If your money is in high-risk investments, it could earn a higher return than your mortgage—only there's no guarantee. "Lower-risk alternatives are the appropriate benchmarks," says Mauricio Rodriguez, chair of the finance department and a professor at the Neeley School of Business at Texas Christian University. "One idea I personally like is investing in a 401(k) or 403(b), where you can use pretax money. At least you're getting the for-sure return of saving on taxes."
3. Your other financial obligations. According to Rodriguez, it's a good idea to prioritize higher-cost debt like credit-card debt and other loans over prepaying your mortgage, since those debts cost more money in interest. "Think about whether you'll need that extra money for other major purchases," he adds. "Will you need to borrow more for that car or wedding?" If the answer is yes, you may want to stick with your mortgage's original payment schedule.
4. Your need for liquidity. Think twice before prepaying your mortgage if it would require you to empty your emergency fund or otherwise sacrifice liquidity. "Having liquidity in the case of an emergency or even just [a source] to draw from for monthly expenses is really important," says Wendy Weaver, a certified financial planner and portfolio manager at fee-only wealth management firm FBB Capital Partners, which serves Maryland and Virginia. "Being able to do so from your savings account or your investment account is a much cheaper way than going into your house to derive those funds." Weaver advises most people who prepay their mortgage to do it through extra monthly payments, which offer more flexibility than a lump-sum payment.
Also consider job stability as it relates to liquidity. "If there's uncertainty, you might want to have a bigger liquidity cushion," says Rodriguez. "I would encourage someone to keep that liquidity cushion instead of prepaying." However, if you prepay your mortgage and open a home equity line of credit, you may still have access to that money at an affordable rate. "The risk with that strategy would be, 'What if interest rates go up a lot?" he says. "That strategy could backfire if two or three years from now, rates are higher."