As a homeowner, being “free and clear” from a mortgage might seem like the ideal situation. You don’t have a mortgage payment, and the home is 100% yours. But is being mortgage-free always beneficial? Is it something you should be aiming to achieve in the long run? Not necessarily.
- Paying off your mortgage will free up your finances, but it may drain your savings to pay off your mortgage more aggressively.
- Stopping interest accrual is a nice perk, but you won't get those interest-cost tax deductions anymore.
- Before deciding whether or not to pay off your mortgage, consider how close you are to retirement, your savings, your current income, and the broader interest rate environment.
What to Consider Before Going Mortgage-Free
To determine whether becoming mortgage-free should be your goal, first consider several factors:
- The terms of your loan
- Your current mortgage rate vs. market rates
- Your household income and expenses
- Your retirement plans
The Terms of Your Loan
Some mortgage lenders penalize you for paying off your mortgage early. Does your loan have any prepayment penalties attached to it? It’s important to understand all terms and conditions that come with your mortgage.
If there is a prepayment penalty, you may owe a large chunk of money for paying off your loan ahead of schedule. Prepayment penalties are most common during the early years of your loan.
In 2014, the Consumer Financial Protection Bureau (CFPB) approved regulations that limit prepayment penalties to the first three years on most mortgages secured on or after January 10, 2014. This limit caps your prepayment penalty at 2% of the prepaid amount for the first two years, and 1% in the third year. By law, you won’t pay a prepayment penalty after the third year if you obtained your mortgage on or after January 10, 2014.
For example, if you had a 30-year fixed mortgage with a balance of $300,000 and had to pay a 2% prepayment penalty, it would cost you an extra $6,000 just to be mortgage-free.
What’s the interest rate on your current home loan? What are interest rates averaging in the current market? Check Freddie Mac for the most recent rates data so you know what your options are.
If rates are lower than what’s on your existing loan, you might be able to refinance, lower your rate and monthly payment, and pay off your loan sooner without eating into your savings or investable cash.
For example, say you have a $250,000 fixed-rate mortgage you got seven years ago at 6.35%, and your monthly payments are $1,685. Refinancing the mortgage at 4.25% for 30 years would result in a $1,244 monthly payment, saving you $441 per month.
You will also need to think about the rate on your loan versus the potential rate of return you could get by investing your money. You may be paying a low interest rate of, say, 3%, but if you could be earning a higher rate of return instead, it may be something to consider.
Remember, investment returns are never guaranteed.
Household Income and Expenses
What’s the state of your household income and expenses? Do you have an emergency fund established, and have you paid off your high-interest debts like your credit cards or car loans? Will you need to pay for your child’s college education soon, or help take care of an elderly parent?
Before paying off your mortgage, it’s wise to make sure your living situation is stable. That may start with building up an emergency fund, which should be at least three to six months’ worth of your living expenses. If you don’t have this money saved and instead use it to pay off your mortgage, you could end up in a bind if a financial emergency happens, and you haven’t yet replenished your fund.
Additionally, if you have large balances on credit cards, consider using any extra money you have to pay those off first. Credit cards often come with higher interest rates that can be over 20.00%, and that adds up fast if you don’t pay them off.
If your income has increased, and you’re financially comfortable, maybe it is a good move to start working toward being mortgage-free. You could make a higher monthly payment toward the principal and shorten the length of the loan. That would allow you to pay off your mortgage sooner and save money on interest over time.
If you aren’t retiring within the next few years, you should also look at your retirement and investment accounts. What does your current retirement and investment strategy look like?
If you haven’t started saving for retirement or just don’t have much stashed away yet, you might want to be more aggressive with your strategy. Paying off your mortgage loan could be a hindrance.
“I like to show my clients the impact compounding interest has on their retirement account,” said Elizabeth Windisch, a Denver-based certified financial planner (CFP) and founder of Aspen Wealth Management, Inc. “If you pay off your mortgage early and wait 15 years to put money in your retirement, yes, your mortgage is paid off, but you’ve lost 15 years on your retirement savings. That’s time you lose that you can’t get back.”
Experts generally recommend putting at least 15% of your annual, pre-tax income toward retirement.
For example, if you were to start a 401(k) with $5,000 and add $300 per month for 30 years at a 7% yearly rate of return, you’d earn $293,547 in interest. However, if you were to choose to pay off your mortgage early and wait 15 years, the same contribution plan would earn $50,333 in interest. If you were to add to your contributions the extra $900 from your paid-off mortgage, your interest earnings would be $173,599 after 15 years.
Pros and Cons of Being Mortgage-Free
One less monthly household expense
No more interest payments on your home loan
Ability to save that money instead
Can fully claim profits on the home when you sell
No longer eligible for mortgage interest tax deduction
Potentially reduces amount you can save while paying off the mortgage
May take time to sell and see profits on your home
It can be tempting to rid yourself of debt and the monthly payments that come with it. According to 2017 data from the U.S. Census Bureau, the median monthly mortgage payment is $900. Freeing up that kind of money each month is hard to turn down. Doing so introduces other benefits, too: You’ll escape interest payments, and you can fully claim any profits on the home once you sell it.
Being mortgage-free would also mean one fewer household expense, which could be helpful if you’re nearing retirement or living on a fixed income. “If someone is close to retirement—say, five to seven years out—I find that people have a greater peace of mind knowing they have no mortgage when they retire,” said Windisch.
On the downside, you’d no longer be eligible for the mortgage interest tax deduction. Losing that tax benefit could put you in a higher tax bracket, resulting in bigger tax liabilities on your annual returns. Additionally, paying off your loan early could reduce your savings or the amount of money you have to put toward your retirement, children’s college funds, or other goals.
Depending on your loan’s interest rate, Windisch said these investments and accounts might net you more than paying off your loan could save.
Finally, another drawback is that while your house is a source of wealth, that wealth isn’t liquid. It may take time to sell your home and see the profits, which could be difficult if you face some sort of financial emergency.
Is Being Mortgage-Free Right for You?
Being a free-and-clear homeowner isn’t always the right move. Be sure to take into account your current loan, your income, and your long-term financial plans.
If you’re not sure what’s right for you and your family, talking to a financial planner and/or an investment advisor may help. The advice you get may give you an overall understanding of how best to use the available money you have.
If you choose not to be mortgage-free, your monthly mortgage payment will depend on various factors, including your home price, down payment, loan term, property taxes, homeowners insurance, and interest rate on the loan (which is highly dependent on your credit score). Try calculating your monthly mortgage, below.