Why Paying Off Your Mortgage Loan Early Could Actually be a Terrible Idea
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- By Jennifer Calonia
- November 29, 2012
Homeownership continues to be a cornerstone of the American dream, and with mortgage interest rates so affordable these days, taking on a mortgage loan can make a lot of sense.
The prospect of paying off a mortgage earlier rather than later often brings relief and elation to some homeowners, but while the idea of owning a home free and clear is a concept that generations past have encouraged, some Americans are no longer on board with this idea, citing disadvantages to paying off mortgage loans before their terms are up.
Drawbacks to Paying Off Your Mortgage
With so much talk of consumers finding themselves neck-deep in debt, the motivation behind paying off a mortgage loan makes sense — after all, mortgage payments are among the largest monthly expenses in U.S. households. But there are deeper financial implications to paying off your mortgage than some homeowners recognize.
1. Mortgage Interest Deduction Lost
The federal government allows homeowners to apply a mortgage interest tax-deduction when filing annual income tax returns. The amount of the deduction depends on your income tax bracket and the amount of mortgage interest paid.
Eric Chen, homeowner and Associate Professor of Business Administration at the University of Saint Joseph in West Hartford, Conn., explains that “interest on a mortgage on a primary residence can reduce income taxes. Quite simply, this is the government’s way of encouraging home ownership.”
While the misconception is that this deduction is reserved only for the wealthy, the National Association of Realtors found that over 60 percent of the families who claim the mortgage interest deduction have household incomes between $60,000 and $200,000. Paying off mortgages early takes this benefit away from homeowners.
2. Miss Out on Low Mortgage Rates Today
Average interest rates on home mortgages surpassed 10% in the late-80s and early 90s, but mortgage rates today are at an all-time low. According to Zillow’s Mortgage Marketplace, the current national average mortgage rate is at 3.25% on a 30-year fixed mortgage.
With mortgage interest rates inching closer to zero, some homeowners are taking the tortoise’s approach when it comes to paying off mortgage loans. Going with the flow of today’s affordable mortgage rates can be a smart choice for borrowers who have other financial priorities in mind. For example, instead of allocating extra monthly funds paying off a home loan faster, homeowners can tap into other investment options like beefing up 401(k) contributions.
3. Potential Pre-Payment Penalties
Some mortgage loan contracts explicitly refer to a mortgage prepayment penalty, also commonly called a “Prepayment Penalty Rider.” This is a provision in the mortgage agreement that legally requires borrowers to pay more if they pay off the entire mortgage early.
Typically, the penalty applies when borrowers pay off their mortgage within the first few years of the loan term, and is usually expressed as a percentage of the remaining balance during the prepayment process, or on interest charges for a predetermined number of months.
4. Reduces Liquidity
When working to pay off your mortgage, you’re essentially tying your liquidity into your home. What this does is prevent you from utilizing your hard earned cash for other unforeseen events.
Idaho homeowner, Nick Drzayich, explains why tying up discretionary funds into a mortgage is a bad move.
“Let’s say I’ve been making extra mortgage payments for the last 10 years. In total, I’ve contributed an extra $20,000 to reduce the principle balance. Suddenly, I lose my job, so I go to the bank and say, “Hey, I’ve been paying extra for the last 10 years; can I have some of that extra to help cover expenses until I find new job?
“They will say, ‘Well, first you have to qualify for that money, and seeing as how you have no job we can’t give you access to that money.’”
Drzayich argues that depositing the extra money into a rainy day fund puts control back into homeowners’ hands. “Simply put, I would have been much better off saving those extra mortgage payments in a side account instead of putting them into my house payment… by making extra mortgage payments you are giving the bank/lender control of that money — it’s no longer yours.”
Benefits of Paying Off Your Mortgage Early
Homeowners who still champion the traditional goal of paying off mortgages identify almost as many benefits to getting rid of mortgage debt as those who oppose this approach. However, the biggest perk to paying off your mortgage loan isn’t necessarily a financially-oriented decision, according to most borrowers and financial professionals.
1. Money to Pursue Other Ventures
As the highest financial obligations homeowners must contend with, cutting down a 15-year mortgage provides homeowners with a substantial amount of wiggle room once the mortgage is fully paid. It is this result that motivated Cynthia Martin of Virginia Beach to aggressively pay down her 15-year home loan in just seven years.
“Paying off my mortgage early gave us the freedom and confidence to launch a start-up out of our house. Until the house and cars were paid off, I felt like we had to remain in jobs that we actually both hated,” says Martin. “Paying off our mortgage early gave us economic freedom and enabled us to explore other much more fulfilling career possibilities.”
2. Low Risk Investment
On the other side of the spectrum, investing entirely in your home presents a low return. Owning a home outright made sense for Florida attorney and homeowner, Shawn Filbert, who decided to pay off his mortgage 22 years early.
“It was good because my rate was 6%, and I didn’t qualify for any federal programs that would have reduced the rate or allowed me to reduce the principal, so paying off my mortgage was like buying an investment with a guaranteed 6% rate of return.”
Filbert acknowledges that investing his extra funds in the market could have generated a greater return than 6%, and that “paying it off doesn’t necessarily put [him] ahead financially.” But it was the guarantee and low-risk environment that paying off his home presented that pulled him in that direction.
“All things considered, I still have mixed feelings about it, but to say you’re feeling guilty about paying off your house is a good problem to have,” Filbert points out.
3. Greater Emotional Freedom
Paying off your mortgage before the 30-year or 15-year term comes to pass still makes a lot of sense to homeowners across the country, but according to John Foxworthy, a Certified Financial Planner in Fort Wayne, Indiana, paying off mortgage debt usually is more of an emotional relief than a financial benefit.
“There are some significant things to take into consideration before recommending that a client pay off a mortgage early… we usually look at the client’s cash flow needs in combination with their emotional need to be debt-free. While paying off a mortgage and becoming debt-free may be a smart emotional decision, it is not always the best financial decision,” explains Foxworthy.
“The funds that are used to pay off the mortgage early might be better utilized for other financial goals like investing for retirement or a child’s education, and it does not make sense to begin any debt reduction plan without ensuring that certain basic financial needs are met.”
Should You Pay Off Your Mortgage?
Determining whether paying off your mortgage loan early is a better decision, compared to dragging mortgage payments through the end of the loan term, primarily depends on the amount of surplus income you have available and what your individual priorities are.
“There is no ‘one-size-fits-all’ answer to this question,” notes Foxworthy. Ensuring that your immediate needs like setting aside an emergency fund are taken care of may very well be a more crucial goal to reach than going all-out on mortgage payments. However, if the sheer thought of being indebted to a lender makes your skin crawl, the satisfaction of paying off your mortgage early can be an immeasurable gain.