Should You Own Your Home "Free and Clear"?
Being mortgage-free may be tempting, but is it right for your finances?
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.
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 can fully claim any profits on the home once you sell it.
Being mortgage-free would also mean one less 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,” Elizabeth Windisch told The Balance via phone. Windisch is a Denver-based certified financial planner (CFP) and founder of Aspen Wealth Management, Inc.
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.
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 Jan. 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 Jan. 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 on 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 a 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. This 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.
And 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. This would allow you to pay off your mortgage faster 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 you just don’t have much stashed away yet, you might want to be more aggressive with your strategy. Paying off your mortgage loan could hinder that.
“I like to show my clients the impact compounding interest has on their retirement account,” Windisch said. “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 started a 401(k) with $5,000 and added $300 a month for 30 years at a 7% yearly rate of return, you’d earn $293,547 in interest.
But, if you choose to pay off your mortgage early and wait 15 years, the same contribution plan would earn $50,333 in interest. If you added to your contributions the extra $900 from your paid-off mortgage, your interest earnings would be $173,599 after 15 years.
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 to best use the extra money you have.
U.S. Census Bureau. "American Housing Survery (AHS)." Accessed Mar. 17, 2020.
Capital One. "Pay Off Your Mortgage Early or Save? How to Decide." Accessed March 17, 2020.
Consumer Financial Protection Bureau. "Ability-to-Repay and Qualified Mortgage Rule." Page 13. Accessed March 17, 2020.
Horizon Bank. "Should You Pay Off Your Mortgage or Invest?" Accessed March 17, 2020.
Fidelity Investments. "How Much Money Should I Save for Retirement?" Accessed March 17, 2020.