Should I Pay off My Mortgage?

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It’s a situation that many Americans dream of. All of a sudden, you come into a large sum of money. You’re finally in a position to pay off your mortgage early — several years or decades before the end of the loan.

The thought of sitting in your home debt-free probably seems life-changing. But as it turns out, using a nest egg or inheritance to pay down a mortgage may not be the best use of your money.

First Things First: What Exactly Is a Mortgage?

First, it’s important to understand what a mortgage is. Many people go through the home-buying process without fully appreciating the unbelievable value that a mortgage provides. For far too many, it’s easy to see a mortgage as a curse instead of a blessing.

In layman’s terms, a mortgage is a debt instrument that a buyer agrees to pay back through a course of predetermined monthly mortgage payments.

Take a closer look at a mortgage, and you’ll find that it’s designed to reward homebuyers. Banks, on the other hand, absorb a high level of risk.

When offering a mortgage, a financial provider essentially agrees to guarantee a loan for hundreds of thousands — or even millions — of dollars. Even then, it’ll take them 15 to 30 years to get it all back, plus interest.

And on top of it, the loan is distributed at just a small fraction of a typical personal loan or credit card interest rate. Purchasing a mortgage essentially enables borrowers to purchase and live in homes that are well beyond the cash they have on hand to buy such a property.

Think about it: You could theoretically put down $20,000 and live in a home that is worth 10 times that amount.

As such, buyers shouldn’t be in a rush to pay off a mortgage by making extra payments. Your money is better off in many places, including retirement accounts, like an IRA or 401k.

The trick is to get the biggest mortgage possible, with the lowest possible interest rate, and hold on until the mortgage period ends.

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Your House Is Not An Investment

One of the biggest pitfalls that investors make when buying a home is to think of their domicile as an investment.

As it turns out, buying a home is not an investment. And as a result, you shouldn’t treat it like one. In other words, a home is a place to live. It’s not like buying a rental property or purchasing a fixer-upper and flipping it for profit.

When you buy a home, you should expect to live in it as your primary dwelling place. Buying a home is a way to build equity, to obtain long-term peace of mind, and to break free from having to rely on landlords and deal with unpredictable living expenses.

How Home Equity Works

The main reason a home is not an investment is that the equity — or ownership value that you accumulate over time — does not collect interest.

This means that, as you make monthly payments and build equity, the value of your house does not automatically increase. Instead, it fluctuates over time. If you’re lucky, it may even skyrocket. But it will do so independent of the payments that you make.

As such, paying off the house in full long before the loan term ends would be like piling cash in your freezer — instead of investing it. You’ll increase ownership. But in doing so you will freeze your money and prevent yourself from gaining stronger returns from stocks, ETFs, and interest payments due to opportunity cost. In fact, you’ll actually increase risk by having all of that money tied up in a piece of property.

That said, if you have already paid down the bulk of your house, you could always consider taking out a home equity loan. You can tap into your home equity line of credit to buy a new car, take a vacation, or put in a pool. Regardless, you should probably consult a financial advisor or financial planner before making such an important decision.

Therefore, it makes much more sense to keep your money and reinvest it over the long term in places like the stock market and other investment accounts. Use the money to buy index funds and mutual funds or to build a reliable emergency fund for hard times.

If you really want to invest in real estate property with your money, consider buying a second property and treating it as an investment. Don’t live in it. Fix it up and rent it or sell it.

Refinancing: A Brief Overview

Instead of paying a mortgage off entirely, most homeowners choose to refinance at some point during the course of the loan, typically to avoid a higher interest rate. After all, nobody likes paying a huge amount of interest each month.

Refinancing a mortgage essentially involves going through the buying process a second time. The process typically takes 30 to 45 days on average and requires several steps, like picking the refinance program that’s right for your credit score, going through an appraisal, negotiating with various loan issuers, gathering financial documents, reviewing estimates, and locking in a new rate.

There are several advantages to refinancing your home. For example, you could decide to take out a home equity loan for various reasons we discussed before. You could also lower your monthly payments or obtain a lower interest rate.

Some lenders also choose to consolidate other debt into a single payment. So if you have high credit card debt or student loans, or even a second mortgage, you might be able to conduct a cash-out refinance. This involves taking out a portion of your home equity to pay down other types of debt.

Refinancing your mortgage could be a great financial move — and something that you should at least look into at some point during homeownership. Even if you don’t decide to move forward with refinancing, it’s a good idea to do a gut check and understand how your financial situation has changed since you originally bought your property.

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Paying the Principal Down Faster

If you have extra money laying around or a healthy cash flow, one of your top financial goals should be to try and pay down the principal on your loan at certain intervals. Making extra mortgage payments can sometimes help you reduce your monthly payments, depending on how your loan is structured.

Paying down the principal amount on your mortgage can reduce the term length by several years in the long run. By taking this approach, you can expedite your mortgage payoff without having to refinance.

If you decide to go this route, consider creating a schedule and recording how often you apply more to the principal amount. It’s not something you have to do every month. In fact, applying more to your mortgage every month could result in you paying down your mortgage too fast if you’re not careful.

Avoiding Prepayment Penalties

One thing to keep in mind when paying down your mortgage is that some lenders can sneak prepayment penalties into the terms of your contract.

Just as it sounds, a prepayment penalty can penalize borrowers for paying all or a part of a mortgage loan early.

Lenders include prepayment penalties to incentivize borrowers to pay back their loan slowly and according to the schedule that they agreed. This is because lenders collect interest on mortgage payments. It benefits the lender to have you pay over a full term, such as a 15-year mortgage or a 30-year term, so they collect more interest and get a better rate of return on their investment in you.

That doesn’t necessarily mean that you shouldn’t avoid paying down a mortgage faster if you have extra cash on hand. Just check the terms of your contract so that you don’t wind up paying too much and getting hit with unexpected fees.

FAQs

Will paying off a mortgage improve your credit score?

A mortgage is an installment loan, meaning that it should be paid off over the course of many years. For this reason, paying a mortgage off over time will not improve your credit score. It may not hurt it, either. The trick is to pay the mortgage down over time and maintain your credit score by keeping credit card utilization fees low and paying all your bills on time.

Is 3% a good mortgage rate?

Heading into 2021, the average mortgage rate on a 30-year fixed rate is roughly 2.88%. So if you obtain a 3% rate, you are in the right ballpark.

If you only qualify for a rate of 4%-5%, that doesn’t mean you should avoid the loan. However, you may want to consider refinancing after you demonstrate your ability to pay your debt and indicate that you’re a responsible borrower to the bank.

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What is a mortgage interest tax deduction?

A mortgage interest tax deduction is an itemized tax deduction that enables homeowners to deduct interest that they pay on a home loan from taxable income. If you own a home, and you do not claim a standard deduction, you should talk to a tax advisor about qualifying for tax-deductible benefits.

Should retirees pay off a mortgage?

Some borrowers may find it beneficial to pay off a mortgage before retiring in order to reduce monthly payments on a fixed income. As an added bonus, paying off a mortgage can also enable you to avoid having to use retirement funds for the same purpose.

The Bottom Line

Let’s face it: All borrowers dream of being debt-free. This is a basic benchmark for successful financial planning.

But the fact of the matter is that debt is just a part of life. While it’s great to avoid bad debt like credit cards and personal loans, installment loans like mortgages aren’t necessarily a bad thing.

If you’re looking to reduce your monthly payments to pad your emergency fund or increase your cash flow, consider talking to your financial advisor to see if it makes sense to refinance. Otherwise, you may want to consider selling your home altogether and downsizing to a more affordable location.

The bottom line is that owning a home can provide a tremendous financial advantage. If you play your cards right, you could set yourself up for strong financial success over time.

Just avoid making hasty financial decisions and doing something rash like paying off your mortgage without considering the implications. You could wind up making a big mistake — even if you have the financial means to pull it off.

Here’s to paying off your mortgage — and timing it perfectly.

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