Coryanne Hicks
Updated ·5 min read
When you operate on a tight budget, it can be hard to decide how to allocate any extra cash that comes your way.
This can leave many homeowners facing a conundrum. On the one hand, no one likes to be in debt, so paying down your mortgage sooner rather than later can be enticing. But on the other hand, there could be better uses for your hard-earned money.
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The key to knowing whether you should pay off your mortgage early is a concept that economists call opportunity cost. What are the things your money could be doing if it weren’t being used to shrink your mortgage?
What it really costs to pay off your mortgage early
Mortgage payments are a combination of interest and principal. The faster you repay the principal, the less you’ll pay in interest over time. It might therefore be hard to imagine a scenario where paying off your mortgage early is a bad idea — but only if you fail to consider the opportunity cost.
Let's say you just get a promotion at work and have an extra $100 to spend each month. You're a financially savvy adult, so you want to use it for something responsible. You could put the money in your savings account, but that might earn you limited interest.
You could seek a higher return by investing the money. The stock market earns on average 6.5% to 7% per year, after inflation, according to analysis by McKinsey & Company.. But the important words there are “on average.” The stock market is volatile: some years, it delivers losses. So, you may need to let things play out for a long time before you net that 7%.
A safer option for shorter-term investments are certificates of deposit (CDs) or Treasury securities, which offer a higher rate than savings accounts without putting your principal at risk. Current CD and Treasury rates are upwards of 5% per year.
All these options represent the opportunity cost of paying off your house more quickly; they’re the investments you cannot make if you put your extra $100 per month toward your mortgage.
And you wouldn’t just be giving up the potential for 5% to 7% in annual returns. You might also lose some of the tax benefit of carrying a mortgage. The Internal Revenue Service lets homeowners deduct the interest expenses on the first $750,000 (or $375,000 if you’re married and filing taxes separately) of your mortgage debt.
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The benefits to paying off your mortgage early
Paying off your mortgage early does have some benefits. It reduces the total interest you'll pay over time, thus lowering your overall cost. Once you've paid off your mortgage, you'll have one less monthly payment, thus freeing up future cash for other expenses. However, for this argument to hold, you have to consider the time value of money. Because some amount of inflation is inevitable, a dollar saved today is worth more than a dollar saved in the future.
Paying off your mortgage early can bring the psychological benefit of knowing you have less debt hanging over your head. But you'd also have less savings in general because of the extra money you were funneling toward your mortgage payments each month instead of into other savings vehicles.
Paying off your mortgage early also means increasing the equity in your home, but this is only beneficial if and when you sell. You could tap the equity through a home equity loan or home equity line of credit, but these often come with even higher rates and less favorable terms than your original mortgage. They're best reserved for a last resort. So if you're worried about unforeseen future expenses, it may be better to build up your emergency savings.
Should you pay off your mortgage early?
Once you understand opportunity cost, it's easier to determine whether you should pay off your mortgage early. The question to ask is which option will net you the highest return.
The interest rate on your mortgage can be thought of as equivalent to the return on investment, so to speak, for paying the loan off sooner. If every dollar applied to your mortgage is scheduled to cost you, say, 4% down the line, you’re effectively saving 4% on each dollar you pay off early. Therefore, a savings vehicle that offers a higher rate of return could be more worthwhile.
This same opportunity-cost argument can be applied to all of your debts. If, for example, you have credit card debt with an 18% interest rate, you should pay it off before investing or paying down your mortgage. Student loan debt, however, tends to have a lower interest rate, so you may be better off only paying the minimum and investing any extra savings.
The rule of thumb: if your mortgage rate is higher than the rate of return you could earn elsewhere, it makes more sense to pay off the mortgage early. Watch out for prepayment penalties, though. Some lenders ding you for paying off your mortgage early. You can see if your loan has prepayment penalties in the "Addendum to the Note" in loan documents.
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This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
