A mortgage-free life may offer a sense of accomplishment and freedom, but diverting excess cash to your home loan could limit you in other ways. These are some reasons why allocating your extra budget elsewhere may prove a better use of your money.
You could lose out on a tax benefit for having a mortgage
If you itemize deductions on your federal tax return, you won’t be able to itemize the mortgage interest tax deduction after your home loan is paid off, since you’ll stop making interest payments. However, you’d still be able to deduct property tax expenses if you qualify.
For most homeowners, the lost deduction won’t affect their taxes. According to IRS data, only about 10% of individual tax returns include itemized deductions. The majority of individual tax filers opted for the standard deduction, which doesn’t allow for an itemized interest deduction.
It may be wiser to channel extra income to higher-interest debt
If you carry credit card or personal loan debt along with a mortgage loan, it probably makes sense to divert extra funds toward that higher-interest debt before paying off your mortgage. The Business Insider reports that the average annual percentage rate (APR) for credit cards in their database ranges from 11%-30%.
When compared to 3%-4% mortgage interest rates obtained in 2020 or 2021, it’s likely that you’ll save more on interest fees per dollar borrowed if you prioritize high-interest consumer debt first before your mortgage.
You might benefit more by investing extra income
Limbird points out that with the historically low mortgage interest rates many homeowners secured in recent years, if you have additional income, paying off the mortgage may not be the best option.
“It might be more advantageous for someone to be putting that extra money into a retirement plan” instead,” she says. Limbird also encourages homeowners to speak with their financial advisor about potential investments. “If your interest rate is 2.5% or 3% … If you could earn more than that [investing], then you’re gonna come out ahead.”
Moore agrees that there’s potential to earn more overall by investing extra cash instead of paying off a mortgage. In some cases, homeowners “can position themselves to pay off the mortgage balance from their investments down the road,” she suggests.
It’s tough to withdraw equity from your home if you need it fast
By making extra loan payments, you increase the amount of equity you have in your home. Home equity, considered an illiquid asset that can’t easily be withdrawn, isn’t easy to tap into if you’re in need of funds fast.
If you’re saddled with an unexpected expense or have an emergency, it takes time to access funds tied up in your home. You’ll either need to sell your home or refinance to access cash from your home equity. If you don’t have an emergency fund that’s easy to access, you may want to reconsider paying down your mortgage balance first.
You may need the extra funds for more pressing priorities
Other financial goals could take precedence over paying off your mortgage. You may want to establish a college account or retirement fund before you channel extra funds to your mortgage. Or perhaps you’re ready to retire an old vehicle. It may make sense to attend to other financial obligations before your home loan balance.
Your loan servicer might charge a prepayment penalty
Some lenders charge a penalty fee if you pay off your loan early, or if you pay a specific amount above what you owe for the month. Prepayment penalties don’t apply to all loans, and lenders must disclose whether a penalty applies to your loan before you sign the loan documents. Under the Truth in Lending Act (TILA), prepayment penalty terms must appear on an applicant’s loan disclosures.
Penalty amounts vary depending on the specific loan terms. Some lenders charge a percentage of the loan amount or interest fees for a set number of months. Other lenders charge a flat penalty fee or apply a sliding fee schedule, where a prepayment early in the loan term triggers one fee, while a prepayment five years later triggers a different penalty amount.
If you decide to pay off your mortgage early, commit to a strategic plan
You’re committed to paying off your mortgage early, but how should you do it? That all depends on your financial standing and comfort level. “I don’t feel that one method of paying off your mortgage early trumps the rest,” says Moore. “The best decision for you is based on your current mortgage terms, financial situation, risk tolerance, and personal goals.”
To determine a strategy for paying off your mortgage, select a method that suits your financial profile. If you receive a pay raise, for example, you may want to commit that extra $200 every month to your loan payment. But if you receive a one-time inheritance, you might consider a single, lump sum payment to reduce your principal loan balance.
