Even if you can pay off your mortgage early…should you? If you have excess cash burning a hole in your pocket, consider the opportunity cost of paying down your mortgage early instead of using the funds to invest elsewhere. While you will save on a portion of the interest expense of your mortgage, you may be better off putting your cash to work for you in a more diversified manner, while maintaining some liquidity.
Calculate your “hurdle rate”
To understand the potential opportunity cost of using free cash to accelerate your mortgage payments, you first need to calculate the true cost of your mortgage. A hurdle rate is the minimum rate of return that’s acceptable to invest in a particular project. In its broadest sense, the hurdle rate is a benchmark for comparison.
Consider the following example:
Suppose the stated interest rate on your mortgage is 3.5 percent and you are in the 28 percent federal income tax bracket. Your after-tax mortgage rate is roughly 2.5 percent, perhaps lower if you can also deduct the mortgage interest on your state income tax return. Consider this your hurdle rate. If, based on your risk tolerance, you expect to achieve a higher annualized investment return by investing in the financial market, then it may not make sense to prepay your mortgage.
Risk versus reward
Depending on your risk tolerance and other investments, the "guaranteed" 2.5 percent savings may be more attractive than a higher expected market return, which is 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. The lower your interest rate, the less you stand to benefit through early retirement of debt.
Other considerations when deciding whether to pay off your mortgage early
The ability to itemize your tax deductions
If a taxpayer’s itemized deductions exceed their standard deduction, they may choose to use the higher itemized amount. For most people, the annual interest expense from their mortgage alone surpasses the standard deduction amount. Without mortgage interest, you may not be able to itemize your deductions.
Especially if you’re charitably inclined, itemizing your deductions can make a big impact on your tax situation. You can only deduct charitable donations if you itemize your deductions. Some other itemized deductions include medical and dental expenses (subject to AGI limitations), state and local income taxes, real estate taxes, certain unreimbursed job expenses, and other miscellaneous expenses.
Before deciding to pay off your mortgage early, understand how mortgage interest fits into your overall strategy to reduce your taxable income.
Diversification and liquidity
Your home is an asset, but how much of your wealth do you want to be tied up in it? While there are ways to access a home’s equity without selling the property, it will require you to pay interest. Essentially, you’ll end up paying the bank interest to borrow against yourself.
Real estate markets are notoriously volatile. Building equity in your home is a good thing, but you’re already doing so with each mortgage payment. Owning your home outright and being mortgage-free is desirable, but make sure you are still saving and investing in other areas that are more liquid.
Diverting excess cash to pay down your mortgage means it isn’t readily available should you need to raise cash. Before paying off your mortgage early, make sure you have sufficient cash flow to save and invest in your other goals.
The decision to pay down a mortgage will vary depending on your life 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.
Those on the cusp of retirement will want to pay close attention to the projected impact on their tax situation. As previously mentioned, mortgage interest often plays a big part in being able to itemize your deductions. Retirees sometimes find themselves paying more in taxes after they retire due (in part) to the loss of many deductions from gross income like contributions to a retirement plan. Many retirees find that they have few options to reduce their taxable income without a mortgage interest tax deduction.
How long do you plan to live in the house? If you anticipate selling the home before successfully paying off the mortgage, this strategy may make little sense for you. If you do plan on living in the home long enough to enjoy a mortgage-free lifestyle, then it is certainly worth considering along with the other factors mentioned here.
Finding a use for excess cash
If you’re thinking about whether you should overpay your mortgage, it means you have some excess cash on your hands. A good problem! As you consider your options, think about your whole financial picture. Do you have any non-mortgage debt to retire? Are you comfortable with your emergency cash reserves? Are you contributing the maximum amount to your qualified retirement plan or IRA? Are there any unfunded major purchase goals within the next five years?
Whatever you decide to do with the cash, find a way to ensure you execute the decision. For example, if you prefer to invest the funds, consider setting up an automatic transfer to your brokerage account. This will save you time but also prevent the urge to spend the money on lifestyle expenses.