When should you pay off your mortgage?
WRITTEN BY: Gideon Drucker, CFP® AIF® ECA
As a financial planner for mid-career professionals, I get versions of this question all the time:
- “Should I use my annual bonus to pay down the mortgage balance?”
- “Should I be putting more to my mortgage each month?”
- “Should I use my excess emergency reserves to pay my remaining balance off?”
Obviously the answer depends entirely on your personal circumstances but for the majority of our Wealth Builder community, I would argue the answer is a resounding...
But, like any nuanced financial decision, the answer is far from black and white so let’s explore when it does and does not make sense to pay off your mortgage more aggressively.
First, let’s discuss when paying off your mortgage or more aggressively paying your monthly’s should not even be a conversation.
If paying off your mortgage would leave you with too small of an emergency reserve or not enough in the bank to pay for those large expenses you have coming over the next few years (like planning for a baby, college education, helping family, taking time off from work etc.) than it’s absolutely not worth making the extra mortgage payment/lump sum….you will be leaving yourself too small a margin for error.
The whole idea of a mortgage is to allow you to take care of your other financial responsibilities while simultaneously paying for your home. Stay the course.
Similarly, if paying down your mortgage would prevent you from contributing enough to your 401k/403b to receive the employer match or to maximize your tax deduction ($20,500 for 2022), than I would argue that you’re effectively just robbing Peter to pay Paul…you’re moving money around.
And as you don’t get to make up those years of MISSED Pre-Tax & Roth retirement contributions down the road, we want to take advantage whenever possible. (If you only contribute $6,000 to your 401k this year, you don’t get to contribute 34,500 next year…you still can only contribute $20,500.)
But let’s assume you’re in excellent financial shape and you really could pay off your mortgage without it negatively impacting your other savings & retirement accounts, then, does it make sense?
Typically, still NO!
Let’s say you bought your home within the last 10-20 years, you probably have a “low" mortgage rate (I would describe anything under 4% as low.)
So the question we have to ask ourselves is, could that $100,000 that you’ve built up and are thinking of using to pay off your mortgage be allocated in a way that will grow at a rate higher than 4%?
Because that’s what we’re talking about: What is the opportunity cost of paying off my mortgage balance?
In other words, what else would I be doing with that $100,000 lump sum if I didn’t put it towards my mortgage?
And that’s the start of the realization that you should start thinking about your mortgage, with an interest rate of 3.5%, not as a liability to be paid off as soon as possible…but rather an ASSET to keep in your back pocket for as long as you can, so your money can work more effectively elsewhere.
I’ll put it like this, if I can pay the bank 3.5% on my mortgage each month but my capital investments are earning 7-8% average returns (which is the historical average for the S&P 500 going back the last 50 years), why would I be in a rush to change that arrangement?
That’s free money!
Only paying the minimum requirement into my mortgage each month IS WHAT’S ALLOWING ME to continue investing my other cash into higher performing assets! Again, It’s a fantastic feeling to know that you COULD pay off your mortgage at any time (and that should be the working goal) but actually paying it off is more of a conversation around opportunity cost and financial return.
Flexibility is another reason to not pay off your mortgage quite yet.
Choosing not to pay off your mortgage today doesn’t eliminate any of your options: you can still choose to pay it off tomorrow!
If however you choose to pay it off today and you end up needing additional cash sooner than you thought, you’ll be strapped for cash and might need to take out a line of credit, home equity lines or other unsavory & unpredictable debt options. From a liquidity standpoint, I’d always rather have that cash/investment in my back pocket with the opportunity to pay off my mortgage within shouting distance than the other way around.
Ok, so when should we explore paying off your mortgage?
First off, if you have a high interest rate and can’t refinance, then the opportunity cost of not being able to re-invest your money isn’t so high….and in that case, it might be worth the peace of mind to eliminate the debt.
And that brings us to the real reason it might sometimes make sense to pay off your mortgage: if it would make you happier to be debt free!
Financial planning is way more art than science...
Some people just absolutely can’t stand debt of any kind and are super motivated to pay it off…It’s one less thing to worry about!
While I would (and just did) make the intellectual/financial argument that mortgages are the “good” kind of debt that are more “asset” than “liability”, your financial feelings don’t have to be rational!
If even after walking through your current cash flow, debt, and opportunity cost position of paying off your mortgage (something we do throughout the Financial Life Plan® process) you’re still committed to paying off the mortgage….we’d probably help you navigate a happy medium! Maybe that means paying off a little bit more each month necessary or using your bonus to take an extra 5% each year etc.
I welcome your thoughts... and as always you can schedule a 15 minute "Right Fit" call so we can figure out together if there's more you can be doing now in your financial world.