It's true: the idea of living without a mortgage payment sounds enticing. On the surface, it may also seem like a no-brainer financially...paying off debts is typically considered a positive thing. Unfortunately, many homeowners get so wrapped up in the debt-free dream, they never run the numbers, or worse, even admit the plan is financially ill-advised but can't shake the desire to live mortgage-free and do it anyways. As with nearly everything in life, there's an opportunity cost that comes with each decision we make. Whether you share the urge to live without a mortgage or simply aren't sure where else to put your extra cash, it's important to understand that prepaying your mortgage may not be all it's cracked up to be.
There is no one factor that will definitively indicate whether a homeowner should prepay their mortgage. The decision must be considered in the context of one's entire financial and personal situation, including mortgage interest rates, free cash flow, other goals, length of time in the home, taxes, and risk tolerance. Even when it is advantageous to prepay a mortgage, the savings may be marginal for some homeowners.
Leverage can be a good thing
Leverage is the idea that an investor's expected investment rate of return is greater than the cost of borrowing funds to acquire an asset. Or put another way, if a homebuyer can obtain a 30-year fixed mortgage for 3.5% and their long-term assumption for investment returns is 6%, they're using leverage to achieve a better financial outcome. As interest rates rise, it may be more difficult for buyers to take advantage of the leverage spread. The opposite is also true: the lower the interest rate on the loan, the more advantageous it can be to get a mortgage and invest cash in the market.
The analysis grows more complex with balloon payments, interest only, home equity lines, or adjustable rate mortgages, as both the potential investment returns and the future interest rates are mostly unknown. It is especially important in these cases to consider your whole financial picture before making changes to your mortgage payment plan. For example, if you have a home equity line of credit (HELOC) with 2 years left on the interest only period and a high variable rate, it may be worthwhile to begin principal payments early if you're very confident you'll remain in the home for many years to come. However, if you plan to move before the principal payments even begin, why prepay?
Length of ownership matters
Whether or not it's a good ideal to prepay a mortgage also depends on how long you plan to own the home. Homebuyers typically feel each home is a forever home, but circumstances often change after a few years. According to a 2017 study by the National Association of Realtors, the average seller lives in their home for 10 years before moving on. That's 20 years shy of the term of a conventional 30-year mortgage! The longer homeowners remain in their home the greater the benefits of paying off a mortgage early.
As an example, assume Brian has a $400,000 30-year fixed mortgage at 4.5%. He lives in the home for 10 years. Brian expects his long-term rate of return is 6% for his investment accounts. Excluding any potential tax benefits, if Brian prepays his mortgage by $500/month, he will have saved $7,368 over 10 years, or $737 per year, compared to if Brian had not prepaid his mortgage and instead invested $6,000 annually (the amount he prepaid).
Had Brian's interest rate been 3% instead of 4.5%, he would have been better off making regularly scheduled payments, excluding taxes. Or, if Brian decided to move out after 5 years, the benefits of prepaying would drop to $1,294, or $258 per year.
As discussed below, it's important to note that because Brian prepaid his mortgage, the extra cash isn't readily available to help him transition to the next property or for other goals. As you consider the best approach for your situation, weigh whether the anticipated annual savings are enough to offset the reduced financial flexibility.
The decision to pay down a mortgage early cannot be made in a vacuum. Depending on your entire financial situation, including other debts, income, and extra savings, prepaying your mortgage could put you in a bad spot. Real estate is a very illiquid asset, and this is particularly true when it's your primary residence. Cash used to accelerate mortgage repayments cannot be reclaimed if you need it later on for another goal (such as college or a down payment on a new house) or in the event of an emergency. While it is possible for some homeowners with a lot of equity in their house to pull cash out through a refinance or a home equity line of credit (HELOC), the costs of doing so would likely fully negate the benefits of prepaying the mortgage in the first place.
Particularly for homeowners during certain periods of their life, such as first time buyers, new parents, empty-nesters, or couples nearing retirement, lifestyle preferences and needs can change quickly.
Your monthly payment won't change
Homeowners with conventional fixed mortgages sometimes think pre-paying their mortgage will change their monthly payment. This is not the case, even if your extra payment is tens of thousands of dollars. Paying down a mortgage early will reduce the life of the loan, which will save you money on interest expenses, but it will not change your minimum fixed costs each month.
To change a monthly payment, you must ask your lender to recast your mortgage to change the amortization schedule on your loan using the new principal balance and the remaining terms of the original mortgage. Recasting a mortgage isn't in the lender's best interest, so they may not agree to it.
A mortgage can provide big tax benefits
Interest on mortgages may be tax deductible for taxpayers who can itemize their deductions. The Tax Cuts and Jobs Act passed in December 2017 included changes to the tax code which will impact many homeowners. State and local tax deductions (including property tax) are now capped at $10,000 and interest paid on home equity debt may still be tax deductible, provided that the proceeds of the loan are used to "buy, build or substantially improve the taxpayer’s home that secures the loan." Further, beginning in 2018, mortgage interest and qualified home equity debt interest may only be tax deductible on new home loans up to $750,000, down from $1,000,000 on loans secured before 2018.
The new tax code also nearly doubled the standard deduction, making it harder for homeowners to benefit from itemizing versus claiming the standard deduction. However, for homeowners who can still itemize, prepaying your mortgage could jeopardize that in the future. Especially for high-income households with a high tax rate, consider working with your CPA to discuss the impact on your tax situation ahead of time.
Other ways to use extra cash
Instead of plowing extra savings into a home or bank account and assuming you've already maxed out your 401(k), consider opening a brokerage account. Unlike retirement accounts which offer tax benefits in exchange for restrictions and possible penalties, a brokerage account has no funding limits or regulations governing when you can tap the account or for what purpose. This infographic has more ways to use extra cash. Having surplus cash flow each month is a great problem to have, but you'll want to fully consider your options and personal circumstances before putting your savings to work.