Should You Pay Off Your Mortgage Early?

Five Reasons Why It May Not Be Best




KEY TAKEAWAYS

  • There are no compounding effects to paying off your mortgage early.

  • Several risks arise when you choose your home as a primary investment.

  • It is harder to save as life goes on and you can't make up for that lost time.

  • Paying off your mortgage early won't completely eliminate your monthly payment obligation on your home.

  • The closer you get to retirement, the more valuable cash becomes.

Over the last 10 years or so, there has been a growing movement encouraging homeowners to pay off their mortgage as soon as possible. While some tout saving $100,000s in interest, others claim that being mortgage-free is financial freedom.


But if you run the numbers and want to plan for the uncertainty of life, then paying off your mortgage is not the path to financial freedom.


Here are five reasons why paying off your mortgage may not always be best.


1. There are no compounding effects.


Most financial experts agree that the secret to achieving financial success is time by way of compounded returns – growth, on top of growth, on top of growth. There are a few well-known experts who embrace the power of compounding but simultaneously advocate paying off your mortgage as soon as possible. These two ideas directly contradict each other.


There are no compounding effects when adding to your mortgage payment. A one-time extra payment will save you a fixed amount of interest, and that’s it. If you want to pay less interest, then you have to keep making those extra payments. Essentially, you’re doing the work instead of making your money work for you.


If you invested that money instead of adding to your mortgage payment, then your money would be working for you EVERY. SINGLE. DAY. Depending on the amount of time you allowed it to work for you, your money could very well amount to 10x your initial investment.


2. Your home isn't your best investment option.


When you focus on paying off your mortgage as fast as possible, you’re essentially choosing your home as a primary investment. There are a few risks with this approach:


1) The value of your home is tied to a market that is not transparent or liquid, and values can go down in times when there is excess supply, rising interest rates, etc.


2) It takes time and a good chunk of money (sales commissions and closing costs) to sell a home.


3) You’re investing in one kind of property (residential vs. commercial, single family home vs. condo, etc.), in one town, in one city, in one state, in one country – not exactly what we would consider to be diversified.


4) What if you never move and your home is your most valuable asset? The only way to access your home’s value is by taking out a mortgage.


5) Over the last 25 years, the average home in the U.S. has appreciated by 3.9% per year in value – not a return to get excited about, especially given the risks noted above.


3. It's harder to save later, and you can't make up for lost time.


People have a tendency to believe that it’s easier to save as you get older and earn more money, but it doesn’t always work out that way. If it was so much easier to save and prepare for retirement when you’re older, then our country wouldn’t be facing a massive retirement crisis.

Let’s say you buy your first home at 25 and have a plan to pay off your mortgage in 10 years. Once paid off, you intend to use that cash flow to start investing aggressively.


There’s so much that can change in your life within those 10 years that can derail your plan. What if you can’t sustain the aggressive payment schedule because “life” happens – would you want that extra cash tied up in your house or would you rather have access to it?


Or let’s assume that you did pay it off in 10 years, and you’re ready to save and invest. Now, you need to save and invest A LOT more every single month just to make up for lost time. If you can’t save more, then you may feel the pressure to be more aggressive with your investments than you’re really comfortable with, which is not a recipe for success.


4. Paying off your mortgage doesn't eliminate your monthly payment obligation for your home.


Debt is a unique aspect of our financial lives because we can almost physically feel the weight of carrying debt. And as a result, the emotional response is often, “I have to pay this off as soon as possible,” but that is rarely the most productive use of your hard-earned money.


Being mortgage-free doesn’t really give you financial freedom. Why? You may not save as much as you think. Remember, your mortgage payment is made up of principal, interest, property taxes, homeowner’s insurance, and HOA dues (if applicable). If you paid off your mortgage, then only the principal and interest portions go away. Yes, you’ll save some money every month, but is that really what’s keeping you from retiring, making a career change, or starting your own business?


5. If you're near retirement, then cash is king.

We commonly see near-retirees become much more aggressive with paying off their mortgage. There’s this notion that you can’t have a mortgage as you enter retirement, but that’s simply not the case. Once again, while you may feel the need to be mortgage-free, there are several reasons why building cash as you prepare for retirement is actually best.

  • If you’re like most people, then the vast majority of your retirement savings is in pre-tax balances that have never been taxed. Your retirement income can be dramatically lower than your pre-retirement income, which means that strategic Roth conversions should be on your radar. Ideally, you should be using cash to pay the taxes on these conversions.


  • During the first few years of retirement, the relationship between market returns and your withdrawals is extremely important. Now that you are relying on your nest egg to support your lifestyle, withdrawals coupled with negative market returns are a double whammy that can raise big questions in your later years. Keeping extra cash can provide you with the flexibility to reduce or eliminate your withdrawals in a down market.


  • If you plan to delay social security benefits, then you’ll be relying on your personal savings to support your lifestyle for a period of time. Having cash on the sidelines will help mitigate the withdrawal stress that you could be placing on your portfolio during those years.


  • Downsizing in a couple of years? The money you just used to pay off your home will come back to you but is tied up in your home in the meantime. When you go to sell, it will cost you time and money just to get that money back.


  • If you’re near retirement, then you’re likely at the point in the amortization schedule where the majority of your payment is going to principal anyway. If you’re going to save very little interest expense, then why drain your cash?


Conclusion


There’s a balance (no pun intended) to financial planning. If you apply all your energy and efforts to just one aspect of your financial life, then you’re neglecting and/or compromising many other important aspects.


As advisors, we’re here to help you identify all of your options, understand the pros and cons for each of those options, and help you make an educated decision. When you have a real plan in place, it makes sticking to your plan so much easier because you’ve replaced anxiety with confidence.


Time is still on your side to build a plan. Make it count.


Frank Iozzo, CPWA®

President, Private Wealth Advisor