When Do You NOT Pay Off Your Mortgage Early?

My husband and I were driving home from dinner out with friends two nights ago when our discussion turned to the topic of money.  I’ve mentioned that recently our family moved to a new house and our money discussion centered on paying down the mortgage early.

I should tell you first that my husband and I rarely agree on anything. This discussion was no different. He argued one side and I argued the other.

You might be surprised to hear that I argued against paying off our mortgage early. But I believe there are better things we can do with our money right now.

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First off it’s important to pay off any debts that are charging higher interest rates than our mortgage loan. Mortgages at this time are some the cheapest money you can borrow. All other loans are usually financed at much higher rates. This is especially true of credit cards. Credit cards usually charge interest rates between 15 and 25%. Why pay off a mortgage charging you 5-7% when you are incurring charges at 15% on your credit card?

In addition, the interest that you pay on your mortgage is tax deductible. You get the greatest tax benefits in the first few years you have a mortgage. That’s the point my family is at right now. We are able to deduct thousands of dollars in interest from our taxes because we’re in the first year of paying it off. It might make more sense to pay off the mortgage early in a number of years down the road when we are not deducting as much interest from our taxes.

I also argued that it’s more important to maximize our retirement accounts. It’s great to be debt free and to have peace of mind knowing our house is paid off but we still need money to live.

What good is it to be debt free if you are broke? I doubt the bank who loaned you the money will show you any compassion if you are unable to pay your mortgage some day after years of trying to pay off your mortgage early. All the money you paid early won’t make any difference at that point.

That’s why contributions to retirement funds will put you farther ahead. Employees that have a 401(k) retirement account are typically incentivized to contribute. While not true for every employer, most match 50% of every dollar contributed up to the first 6%. If you’re not contributing enough to at least get the full company match, you’re leaving free money on the table.

401(k)’s aren’t the only retirement savings vehicle out there. No matter what type of retirement plan you have and whether or not you get a company match it’s still a better choice to maximize your contributions each year. Some retirement savings accounts allow you to make contributions with pre-tax dollars. This essentially lowers your taxable income possibly bumping you down to a lower tax bracket. Sure, the money is taxed when it is withdrawn but most people’s tax rates fall in retirement compared with the period when they made the contribution.

I also brought up the fact to my husband that my income can vary wildly because I work on a per project basis. Some months I make 2x’s as much as other months. That’s why it’s so important for us to have an emergency fund to tap into, to cover the ups and downs.

Typical emergency funds have enough cash in them to cover 3-6 months’ worth of expenses. Long time readers will know that I believe this advice to be inadequate. I advocate for keeping enough cash to cover one year’s worth of expenses. I believe the increased margin for safety is necessary because it’s now much harder to find a job that pays just as well than it was two years ago. People returning to the workforce from long stretches of unemployment often have to take jobs that pay substantially less than they were making at their previous job. Having an emergency fund with enough cash to cover one year’s worth of expenses can be the difference between a rough patch and financial ruin.

The best argument against making extra mortgage payments is opportunity costs. In other words, I’m saying that you could make more money through investing your extra cash than you would by paying down your principal.

If you have a mortgage interest rate around 5%, why pay off that loan when you could be earning 8-10% on your extra cash through investments. Earn more with your money than you would by paying off your mortgage debt.

We are all taught that the stock market historically returns 10% a year (though this isn’t always a given).  Anyone can see that earning 10% on your money is better than paying off 5%. Even if the margins are closer it still makes sense. Any money you invest simply needs to earn more than your current mortgage rate to get the biggest bang for your buck.

And the rate you get on paper for your loan is not the real interest rate you’re getting if you deduct any interest on your taxes annually. For example let’s say your family makes a combined $100,000 a year. Let’s say then you are paying around 25% of your income in taxes: local, state and federal. If you pay $12,000 a year in mortgage interest on a loan that charges 5%, the deduction brings your taxable income down to $88,000 a year.  The mortgage interest deduction would lower your taxes by $3,000 (25% times $12,000) for that year. In turn this effectively lowers your after tax mortgage rate to 3.75% (25% lower than your current mortgage rate).

Earning more than 3.75% on your money seems very reasonable even in a market downturn like our current one.

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Despite the sound financial sense my arguments made my husband brought up a good point, no one that has every paid off their mortgage loan early has regretted it. You never hear those people acknowledge the big gains they might have made by investing the money elsewhere. The emotional reward one gets from living 100% debt free and being beholden to no one can be too strong to counteract with sensible financial advice like I’ve presented above. This is especially true of people nearing retirement who are determined to quit work with no debt attached to them. In fact if you are near or are in retirement this is one of the few times I would advocate paying off your mortgage early, provided all other debts with higher interest rates are paid off first. Your housing expenses are your biggest expense so it makes sense to cut it down in retirement when you are living off less income. Plus, trying to make mortgage payments in retirement often means taking larger distributions from tax-deferred retirement accounts which can make your tax situation worse.

Another thing to consider is being upside down on your mortgage.  I would suspect this is true for most Americans. Why rush to pay off an asset that’s worth significantly less than what you owe.

Truthfully this question can’t be satisfied with a one size fits all answer. Each person’s situation is different. Instead of pretending to know what’s best in your situation, I told you what my family is doing. We believe our money can be better served making us money through investments rather than paying off our mortgage early. Most likely we will change our minds as the amount of interest we can deduct each year goes down.

Keeping Money In Your Pocket,

Nancy Patterson