When Not To Pay Off a Mortgage Early

Money Girl answers a listener question about paying off a mortgage early and explains when to do it--and 3 situations when it’s a bad idea.

Laura Adams, MBA,
July 30, 2014
Episode #364

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Situation #1: You don’t have emergency savings

Before you send one extra dollar to your mortgage, be sure to have plenty of cash in an FDIC-insured savings or money market deposit account. Make it a goal to always keep at least 3 to 6 months’ worth of living expenses on hand.

Even though you won’t earn much interest on your emergency savings, its purpose is to keep you safe if you get into an unforeseen financial hardship. Therefore, if you don’t have a healthy emergency fund, don’t even think about paying down your mortgage early.

Situation #2: You have high-interest debt

Never pay down a low-interest debt before a high-interest one. Tackling high-interest debts first saves you the most money in interest, which allows you to pay off lower-interest debts even faster.

As a general rule, mortgages are cheap money. Right now, the average annual cost of a 30-year fixed mortgage is 4.3%. (If you’re paying at least one percent more than the going rate for your type of loan, contact your lender about refinancing your mortgage at a lower rate.)

Additionally, you may be eligible to claim the home mortgage interest tax deduction, making your home loan cost even less on an after-tax basis. You never get a tax break for interest paid on other types of debt (except for a certain amount of student loan interest, if you meet income limits).

So why pay down an inexpensive mortgage when you could be using your money to get rid of outrageously high consumer debt or car loans instead?

Situation #3: You’re not investing for retirement

Investing for a comfortable retirement is one of the most important financial priorities we have. Using a tax-advantaged retirement account, such as an IRA or a 401(k) plan at work, will cut your taxes and turbo-charge your savings.

If you’re not saving a minimum of 10% to 15% of your gross income for retirement every month, then putting extra money toward a mortgage is a bad idea.

See also: Whether to Invest or Pay Down Debt

Should You Pay Down a Mortgage with a Lump Sum or Monthly Payments?

Now, back to Julie’s question. If her finances are in great shape with a fully-stocked emergency fund, no high-interest debt, and regular contributions to a retirement account, then sending money to her mortgage is a great idea.

Julie is wondering whether to make a big lump sum payment, or spread it out over time using a series of smaller payments. My answer: the faster you reduce your mortgage balance, the less interest will accrue.

For instance, making some assumptions about Julie’s loan shows that making a one-time $20,000 payment would likely save her about $40,000 in interest over the life of the loan. On the other hand, spreading it out and sending an additional $166 per month over a 10-year period would save her about $30,000 in interest.

Sending a lump sum amount to your mortgage always gives you the most interest savings; however, it’s riskier than sending a series of small additional payments, because you’re giving up a large amount of cash at once.

Also key: whenever you pay extra on your mortgage, be sure there is no prepayment penalty (as Julie mentioned), and that the additional funds will reduce your principal balance, not just get set aside to cover the next monthly payment.

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House and Piggy Bank Balancing and Interest Rates images courtesy of Shutterstock


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