While making monthly repayments on your mortgage, it can sometimes be tempting to overpay or pay back extra every month to pay off the mortgage earlier than scheduled. That’s because the idea of becoming debt-free appeals strongly to the average person (unless you are the federal government, Spain, Chicago, or California!). Sometimes it may be even be an attainable goal, depending on your current financial situation.
Assess Your Opportunity Cost
But even when it is feasible for you to pay off the mortgage faster than your original plan, should you really do it? To answer this question in an objective and financially astute manner, you must first assess your opportunity cost of early repayment of the mortgage at the expense of your other needs or investment options.
When you pay off the mortgage early, it will save you a considerable amount in terms of additional interest costs that you would have otherwise incurred as part of your regular repayment schedule. This saving is usually significant, and increases with your prepayment amount. And in a time of outstanding tax cuts and so on, there is nothing wrong with saving money.
But you have to evaluate the other side of this bargain. By directing your surplus funds towards the early repayment of your mortgage, you won’t have those funds available any longer for investment. Particularly, if your mortgage interest rates were low, the amount of potential saving through earlier retirement of debt would also be lower.
How to Make a Decision that Maximizes Your Benefit?
In order to understand the opportunity cost versus benefit, consider this example:
Let us assume that your mortgage interest rate is four percent, and your federal income tax rate (as per your income bracket) is 28 percent. This means that your post-tax mortgage rate would be somewhere around 2.9 percent, or slightly lower if you are also able to deduct the interest on your mortgage in the tax return in your stage.
So, 2.9 percent is roughly the effective saving available to you in the event of early retirement of mortgage.
Now if you are the type of investor who has a relatively higher risk appetite, and you aim for an annualized return on investment to be significantly higher than 2.9 percent in your portfolio, then retiring your mortgage early would not make financial sense.
On the other hand, if you are someone for whom a predictable financial situation and a “guaranteed” saving of 2.9 percent is more appealing than a future expectation of higher returns subject to market risks, early repayment of mortgage may become a more desirable strategy (more so, if you have a high post-tax mortgage rate).
So you need to ask yourself, what are your investments earning for you?
Other Factors to Consider
For some people, the option to deduct interest on the mortgage from their income tax is a vital aspect of their tax planning. In this case, you should determine whether in absence of mortgage interest you can still itemize deductions or not.
Consider at a pragmatic level whether you have the commitment and the risk tolerance to invest the money that could have been used to retire your mortgage, or would you end up spending it. You should also consider the options of increasing the monthly contribution to your 401(k) or a direct deposit in the brokerage account. These options can ensure that you put the money in the right investment vehicles and forget it.
Apart from your current capacity to invest surplus funds, consider whether you have any other pressing goals or priorities on the horizon that would require those funds. Consider your complete financial situation in an objective manner, including any credit card debts, student loans, and the level of your emergency cash reserves.
Stage of Life
Consider at what stage of life you are at present and what may be your time horizon to live in your home. In case you are nearing your retirement, a rather conservative allocation of assets may be a good idea, while making aggressive market investments could be a risk you don’t really need to take.
Choose a Balanced Approach
As you evaluate your options, keep your expectations realistic, and make sure you should have a well-considered plan in place to accomplish your goals. Talk to a solid financial advisor (be careful if their name is Napoleon Dynamite!) before you commit to a mortgage repayment strategy. Just like with any other important decisions in life, it pays to have an open mind and a flexible, balanced approach to this decision.