By Thomas Morr, CFP®, CAIA
Whether or not to pay off your mortgage early is an important decision. When you own a home, and are making regular payments, it’s natural to think about how nice it would be to eliminate mortgage payments every month. However, before you decide to put a large chunk of capital towards your mortgage, consider the following factors.
Where Can You Get The Most Growth?
The most important factor when evaluating your options is that of growth. You don’t want to leave your assets in a savings or checking account where you’re earning less than a percent of interest. You want your money to work for you, so the question to ask is, “What option will give you the biggest payoff?” When it comes to paying off your mortgage, first take a look at your interest rate. If the rate on your mortgage is low, you might be better off investing your cash.
Let’s say your mortgage interest rate is 5%. If you estimate that, based on your risk tolerance and time horizon, you can pursue an investment return of 7-9%, you would have more to gain by investing in the higher returning opportunity than by paying down your mortgage. When you consider that the annualized return for the S&P 500 has been roughly 10% over the last 90 years, and that mortgage rates are at all-time lows, it appears that there is more to gain by staying invested.
Any choice is a risk, however. An unexpected event could cause markets to crash, or real estate prices could plunge, leaving you with a potential loss. It’s important to run a thorough analysis and consider taxes on investments, mortgage interest deductions, and private mortgage insurance, among the other elements of your financial life. An experienced financial advisor can run various scenarios for you and help you carefully consider what risks you’re willing to take.
Your Liquidity Needs
Your home is considered an illiquid asset because it can take months, or longer, for you to find a buyer and receive proceeds from the sale. If you put a large portion of your liquid assets towards paying down your mortgage, it is, for all intents and purposes, gone. The only way you’ll gain access to those funds again is by selling or taking out a home equity loan. So, consider your cash flow needs and if you tend to have a high monthly output, you may be better off keeping cash on hand.
Now let’s consider the opposite perspective. By paying off your mortgage in full, you will have more flexibility to put your income towards other expenses, or to save it. This approach generally works best for people who are planning to work for another 5-10 years, so that they can funnel their future earnings towards other financial goals. Plus, having liquidity on hand enables you to take advantage of market cycles, and to make investments when compelling opportunities arise. Whichever way you look at it, the goal should be to ensure that you have enough of a cushion in place before making a large mortgage payment to avoid running into any cash flow issues.
Is Debt-Free Important To You?
How does being debt-free sound to you? For some, the peace of mind that being debt-free can create can outweigh any potential benefits to their bottom line. This is where financial planning is both an art and a science. If paying down your mortgage will relieve you of a stressful burden and help you to feel more secure in your financial life, than do it. I’ve worked with clients who felt a great deal of comfort knowing that their home was paid for in full as they approached retirement and prepared to live on a fixed income. Remember, it’s your money! Consider your values and which approach will serve you best from a financial and an emotional perspective.
It’s Not All Or Nothing
For some people, it may make more sense to choose a combination of these two approaches. If your mortgage has no prepayment penalty, an alternative to paying it off entirely is to chip away at the principal. You can do this by making an extra principal payment each month or by making periodic payments. Just make sure that you work closely with your lender to specify that the additional money you’re paying should be applied to your principal and not used to pay down interest on your next scheduled payment. This tactic can save you a significant amount of interest and shorten the life of your loan while maintaining your diversification and liquidity.
Paying Down a Portion Of Your Mortgage
Another option you have is to strategically pay down your mortgage while retaining your ability to take the interest tax deduction on your tax return. As of the time of this writing, you can deduct home mortgage interest on your 2020 tax return on the first $750,000 (or $375,000 if married filing separately) of indebtedness. Higher limitations, $1 million ($500,000 if married filing separately) apply if you are deducting mortgage interest from indebtedness incurred before December 16, 2017.
While almost all homeowners qualify for the mortgage interest deduction, you can only claim it if you itemize your deductions on your return. So, you only want to itemize your deductions if you expect that they will exceed the standard deduction. The standard deduction for the 2020 tax year is $12,400 for individuals, $24,800 for married couples filing jointly, and $18,650 for heads of household.
The mortgage interest deduction allows you to reduce your taxable income by the amount of interest paid on the loan during the year, not the principal. If you are in a higher tax bracket, and have a large mortgage, you’ll want to calculate the amount of interest you pay on your mortgage each year before deciding to pay off your mortgage in full. You could potentially be missing out on a valuable tax benefit.
Another option to consider is refinancing. At present, interest rates are at historic lows, so if you secured your mortgage during a higher interest rate period, refinancing may make sense for you. Lowering your interest rate can reduce your monthly payment which would then help your cashflow. Be sure to pay close attention to refinancing fees which can range from 2%-5% of the loan balance due. It is prudent to do a thorough analysis (or ask your advisor to do one) of your mortgage rate, the costs to refinance, and the potential savings a lower interest rate could yield, to see if a refinance makes sense to you.
As you can see, there are several variables to consider. Paying off your mortgage is a big financial decision, and before making such important decisions, it is always a smart idea to consult with a financial advisor. At Simon Quick, our advisors can give you personalized financial planning and investment advice tailored to your needs. If you’re interested in learning about working with an advisor, call us at 973-525-1000 or email Info@mqsadvisors.com.
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