Should you pay off your mortgage early? (© Image Source/

© Image Source/

Should you pay off your mortgage early?

It's a question many people wonder about, whether they're thinking of making extra payments each month or paying it off all at once with a lump sum. After all, who doesn't look forward to the day when they don't have to write that big check to the mortgage company every month?

On the other hand, there might be better uses for your money, especially when mortgage rates are so low. No wonder the experts are split. (Bing: Just how low are mortgage rates right now?)

Let's take a look at some of the considerations in deciding whether it makes sense for you:

How much would you be saving on your mortgage?
The answer for most people is not a whole lot. That's because interest rates are still near record lows and you can deduct that interest from your taxes. For example, if you have a 4% mortgage rate and you're in the 25% tax bracket, your after-tax mortgage rate can really be about 3%.

If your rate is still high, you may want to consider refinancing instead. This calculator can help you determine how long it would take to recoup any costs you may pay in a refinance. But even if you're stuck with a relatively high interest rate because your credit isn't so great or your home is underwater, or if you don't benefit much from the tax deduction, you still need to compare your savings with the other uses you might have for that money.

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Do you have sufficient savings for emergencies?
It won't do you much good to pay down your mortgage if you may have trouble making the remaining payments if you lose your job. A rule of thumb is to have between three and 12 months of necessary expenses somewhere safe and accessible such as a savings account or money market fund. The exact amount can depend on how secure your household income is.

Some people think that paying down their mortgage can reduce their need for emergency savings since they can borrow against their home equity, but there are a couple of problems with this. First, as we've learned over the past few years, home equity can drop just like the stock market. Second, even if you have plenty of equity, your mortgage company can cancel your home-equity line of credit at any time and is most likely to do it right when you most need the money. Think of home equity as a potential low-cost source of credit for things such as home improvements and college funding, but not as your emergency fund.

Do you have high-interest debt?
Your mortgage is generally considered to be "good debt" and there's a reason for that. The average 30-year fixed rate is less than 4%, and rates for 15-year and adjustable-rate loans are even lower. Compare that with the average interest rate on a credit card with a balance, which is more than 10 percentage points higher. Other debt such as payday loans can be much higher. If you have any of this "bad debt," paying it off first should be a priority simply because it's costing you so much more in interest.

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Are you taking full advantage of your retirement accounts?
At the very minimum, you want to make sure you're getting your employer's full match before making extra mortgage payments. Otherwise, you're leaving that free money on the table.  Even beyond that, you're still often better off contributing to your retirement plan because of the tax benefits and the potentially higher returns on your investments than what you're probably saving on mortgage interest. A 2007 study by the Federal Reserve found that the 38% of U.S. households currently paying down their mortgage at the expense of retirement-plan contributions are losing benefits of between 11% and 17%, depending on their choice of investment. While the benefit would be smaller, this would apply to investing in stocks in taxable accounts too, since their historical long-term annualized returns have averaged between 8% and 10%.

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How conservative are you?
None of the above — except the employer match — applies if you're going to put your retirement savings into a money-market fund earning less than 1%. If you're very conservative and unwilling to take any risk, paying down your mortgage early may be your best option, since it's like getting a guaranteed tax-free return equal to the mortgage interest rate (less any applicable deductions). I don't know about you, but I don't know anything paying a guaranteed 3% to 4% right now.

Just be sure that you can actually retire with that low of a return on your savings. Some people can retire comfortably on just Social Security and pension income once their mortgage is paid off, while others will have to save more. What you don't want to do is wait until the market is doing better to become more aggressive, because that's the recipe for buying high and selling low.

Are you in or approaching retirement?
The calculations look a little different at this point. If you've had the mortgage for a while, you're probably paying little or no interest, so you're not really benefiting from the tax deduction. You also won't benefit as much by investing the money instead, since your investments are likely to be more conservative. If you're retired, you're not eligible to make contributions to a tax-advantaged retirement plan anymore. In fact, you may need to make withdrawals from those accounts just to make the mortgage payment. If you have five years left on your mortgage, who knows how well the investments in those accounts will do in the next five years? For all these reasons, it may make sense to pay off the mortgage early.

There are a couple of other things to keep in mind. First, if you're making large withdrawals from retirement accounts, you may want to space them out over two or more years to avoid having them taxed at a higher tax bracket. Second, if you're paying it off over five to seven years, it could make sense to refinance to a 5/1 or 7/1 adjustable-rate mortgage so you'll pay less interest during that payoff period. Just make sure that you'll save more in interest than you'll pay in refinancing costs.

How would being mortgage-free make you feel?
Those are all the financial considerations. However, there's an emotional component to this, too. After examining the financial impact of your decision, you may decide the financial loss is worth the peace of mind you'd get from being free of your mortgage a bit earlier. In that case, there's nothing wrong with your decision, as long as it's an educated one.