Alexander Hamilton has been popular recently, so we’ll let him give you some wise words on debt: “A national debt will be to us a national blessing, if it is not excessive.”
The father of American economics may never have taken out a mortgage, but he would have understood that such a debt would be “good.” This is a term for debt that will ultimately improve your net worth, whereas bad debt is the variety that won’t. Taking out a mortgage on a home is “good” debt because, if you care for the property, you can consider that property an investment that will ultimately return a higher value to you. Taking a loan on a sports car is “bad” debt because its value drops as soon as you drive it off the lot (unless you keep it in pristine condition for a collector 50 years down the line).
The point is this: If you’ve collected a healthy amount of savings across the life of your mortgage, you may be tempted to pay the whole thing off. After all, paying it quicker means less spent on interest down the line. It seems like common sense… but in many cases, it won’t actually be your best course of action.
Check out this list of scenarios as a guide for when paying off—or not paying off—your mortgage is a better option. There’s rarely a black-or-white answer, so be sure to speak with your lender to find out what is ideal for your case.
Don’t pay off your mortgage if you can make more money elsewhere.
There’s one major way that borrowers can get money back from their mortgage situation: Most loans allow the homeowner to deduct some degree of interest they pay on a mortgage from their taxes. So let’s say you’re in the 25 percent income tax bracket, and you’re in the 25th year of a 30-year fixed rate mortgage worth $200,000 (at 4 percent).
You’ll owe $54,357 in principal across the last five years of that loan. If you have enough in savings to pay off your mortgage now, rather than waiting, you would ultimately save $6,446 from future interest payments. That sounds great (and it is). But is it possible that there are even better ways to earn?
If you honestly had nearly $55,000 sitting around for other use, what would happen if you invested it instead? Assuming you simply let that sum sit in a Roth IRA at 6 percent—with no further investment—it would have netted you a further $18,000 over the same five years. And, the cherry on top, is that you would be able to deduct a total of $1,612 in interest from your taxes over the last five years of your mortgage.
The formula below is a bit oversimplified, but it gives you a good idea as to whether you should pay off your mortgage or invest those funds elsewhere.
(Interest Earned from Investment) + (Tax Deduction of Mortgage Interest) = X
If “X” is greater than the amount you would save from paying off your mortgage early, then you should invest instead!
Don’t pay off your mortgage if it will leave you in a bad place financially
Let’s say you’re in the same position as above: You have $55,000 in savings that you can use to pay off your mortgage five years early. And maybe you’ve already got a 401(k). So does that mean you should go ahead and pay that sucker off?
Maybe. But you need to do some serious self-consultation first. We commonly advise potential borrowers to make sure that they’ve got a three-month “Rainy Day” fund before they buy a home. This is flexible cash that you can use in case of an emergency. Funds such as a 401(k) don’t quite fit, because they often involve penalties for early withdrawal.
If you’re paying into your own retirement, or pay your own health insurance, you may want to make sure that you’re in a solid place before dropping a large amount to pay off your mortgage. And even if you can afford to let that money go, it’s better to pay off your “bad” debts first—things such as credit card bills, car payments and student loans.
Maybe pay off your mortgage if you have Private Mortgage Insurance
One of the most foolproof occasions for paying off your mortgage early is if you pay Private Mortgage Insurance on your loan. Typically, lenders require that borrowers take out PMI until they own 20 percent equity in a home.
The good news: This means that you don’t need to pay off your entire mortgage to benefit from taking PMI off of your monthly payment. Instead, you only need to pay off 20 percent of the principal. So, if you got into the aforementioned home with 10 percent down, you would owe $20,000 in principal payments before you can shake free of your PMI. The other benefit to paying off this $20,000 faster than necessary is that it will ultimately lessen your total interest paid across the life of the loan.
These were just a few examples where a borrower may or may not want to pay off your mortgage early. Remember however that there are few cookie-cutter cases in the real world and you should always speak with your lender to determine what will work best for you. Good luck!
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