If you’ve got extra money, you may want to put extra toward your monthly mortgage. But what are the pros and cons of prepaying your mortgage? Financial advisor Matt Becker weighs in.
If you’re anything like me, you’re probably sitting on your couch right now thinking:
“What the heck should I do with this big pile of extra money I have laying around?”
Oh wait, that’s not you? No, me neither.
But you may have a little extra money each month, and if so, you may be wondering what to do with it.
One attractive option is putting some of that extra money towards your mortgage. After all, who wouldn’t like to be mortgage-free a little sooner?
But is paying your mortgage off early a good idea? It certainly can be, but there are also some potential pitfalls to avoid.
So that you can make the right decision for your specific situation, here are the pros and cons of prepaying your mortgage.
Pros of Prepaying Your Mortgage
1. You’ll Get a Consistent Rate of Return
Every extra dollar you put towards your mortgage gets a rate of return equal to your mortgage interest rate (with some exceptions, which we’ll get into below).
That’s in sharp contrast to the roller-coaster ride of the stock market, which has the potential for higher long-term returns at the cost of short-term uncertainty.
Sometimes it’s nice to know exactly what you’re getting.
2. You’ll Have Flexibility
As you pay off your mortgage, you increase the equity in your home. And that equity gives you the flexibility to change your living situation when you get that dream job offer in a different city, or you decide that being an international nomad is your true passion.
First, you’re more likely to avoid the trap of getting behind on your mortgage, which is when your house is worth less than you owe. That situation can make it difficult or even impossible for you to sell and move on.
Second, if you do sell, you’re more likely to walk away with some cash that can serve as a launch pad for the next stage of your life.
3. Financial Independence Gets Easier
The amount of money you need for financial independence is directly tied to your expenses. The less you spend, the more you have to save.
Paying off your mortgage relieves you of a big expense—maybe the biggest expense in your budget. Which means that your freedom number will be smaller, and you may be able to reach financial independence even sooner.
4. You Can Plan for Other Expenses
Let’s say you have a newborn baby and a 30-year mortgage. What if you could accelerate your mortgage payments on a schedule that had it paid off in just 18 years?
That would mean that your big house payment would be coming off the books right when your child is entering college. That could make it much easier to afford those tuition payments and get your child through school without either of you incurring too much debt.
Cons of Prepaying Your Mortgage
1. You May Have a Prepayment Penalty
Certain lenders restrict the amount you’re able to prepay and charge a penalty for anything over that amount.
If you’re subject to a prepayment penalty, one option is to refinance to a mortgage without any penalties. Depending on the specific terms of your current mortgage, though, refinancing may be subject to a prepayment penalty. It still may be worth it depending on the size of the penalty, the terms of your new mortgage, and your future prepayment plans.
You can either review your mortgage contract or call your lender to ask about your specific prepayment terms.
2. You May See Potential for Better Returns Elsewhere
While prepaying your mortgage offers a consistent return, it may not offer the best return.
Historically, the stock market has returned about 9.5 percent a year. That comes with a lot more year-to-year variation, and nothing is guaranteed going forward. But those historical returns are significantly higher than most mortgage rates.
Or you might have other debts with higher interest rates that represent a better rate of return. For example, putting your extra money toward a student loan with a 6.8 percent interest rate will provide a better return than paying off a mortgage with a 4 percent interest rate.
Everything comes with a trade-off, but you’ll want to evaluate all your options to make sure you’re getting the most out of your money.
3. Your Lost Tax Deduction May Hurt Returns
Not everyone can take the mortgage interest deduction on their taxes, but for those who do, the return on your extra payments is actually less than your mortgage interest rate—you lose percentage points.
For example, let’s say that your mortgage interest rate is 4 percent, you’re in the 15 percent tax bracket, and you’re eligible to take the full deduction. In that case your effective interest rate is only 3.4 percent, since some of your interest payment is offset by the tax break. In that case, any extra mortgage payment earns a 3.4 percent return rather than a 4 percent return.
It’s still a net win. Not paying interest is better than paying interest at a discount. It just may not be as big a win as it first seems.
4. Your Other Needs May Come First
As with any financial decision, paying off your mortgage early should be evaluated in the context of your other financial goals.
Depending on your specific goals and circumstances, you may want to put other financial moves first.
Prepaying your mortgage can be a fantastic use of your extra money. It offers a consistent return and gives you the flexibility to pursue whatever opportunities come your way.
But before you dive in, double-check the terms of your mortgage to make sure you won’t be hit with any penalties, and make sure you have your other financial priorities lined up as well.
That way you’ll be able to take full advantage when the opportunity arises.
Matt Becker is the founder of Mom and Dad Money, a fee-only financial planning practice dedicated to helping new parents build happy families by making money simple. His free time is spent jumping on beds and building block towers with his two awesome boys.
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