Should You Pay Off Your Mortgage Early?
Soaring inflation rates combined with historically low interest rates make 2022 one of the worst periods in history to pay off a mortgage early, however there are times when it makes sense to pay more than the minimum. In this blog post we cover situations in which you should make only the minimum payments and a few situations in which you should consider paying down your mortgage more aggressively.
WHEN TO CONSIDER MAKING ONLY MINIMUM MORTGAGE PAYMENTS
You Have a Fixed Rate Mortgage Locked in at a Low Rate
Inflation, as measured by the Consumer Price Index (CPI), is the highest it’s been in 40 years. The latest CPI number came in at 8.5%, and while high inflation is generally terrible for consumers it can actually be very beneficial for borrowers who hold fixed, low interest rate debt. For example, many borrowers are currently locked into 30-year mortgages at rates near 3%, which means your mortgage debt has deflated away at a real rate of around 5.5% (8.5% CPI - 3% mortgage interest) over the previous year. So, all else remaining equal, the longer you let that debt sit the more it gets deflated away as the dollars your mortgage debt is denominated in are worth substantially less each year. Additionally, inflation compounds on itself, so your debt can deflate away significantly over just a few years.
You Itemize your Tax Deductions
If you earn a high income then you most likely receive a large tax deduction for the interest portion of your mortgage payments. In 2022 you can deduct the interest on up to $750,000 in mortgage debt. If you locked your rates prior to 2018 then you can deduct the interest on up to $1,000,000 in mortgage debt. This effectively makes the interest rate a lot lower than the actual rate. For example, a 3% interest rate mortgage is effectively closer to 2.5% if you factor in the tax deduction. This potential tax deduction can be significant and can make large mortgage payments easier to stomach.
You Are Comfortable With Markets and Have a Relatively High Risk Tolerance
Paying 3% interest on a large loan like a mortgage can equate to a lot of money going toward interest payments so it’s very tempting to pay that off as soon as possible, however historically you can make close to an average return of 8% in a diversified stock portfolio (if you can withstand the volatility). This means you may be better off investing those extra dollars as opposed to paying down your mortgage. Keep in mind that this makes sense from a pure financial perspective, but this doesn’t mean it’s always the best choice for any given individual.
WHEN TO PAY EXTRA TOWARD YOUR MORTGAGE PAYMENTS
You Have a Variable Rate Mortgage
If you have a mortgage with a variable interest rate such as a 7-1 ARM then it may make sense to pay off your mortgage quickly. This is because mortgage interest rates could continue to rise, and your mortgage payments could become rather high. The difference between a 3% interest rate and an 8% interest rate on a mortgage is substantial and can result in thousands of dollars added to each monthly mortgage payment If you have a large mortgage. The exception to this is if you know you will be selling your house before the rate can adjust up too high. Another exception is if your ARM has a low cap on the adjustable interest rate.
Your Income Will Not Increase with Inflation
I explained above that inflation can work to your advantage if you own low interest rate debt, however this may not be the case if your income will not increase as inflation increases. If your income is not increasing, then you may not benefit from your debt slowly deflating away. Your debt will still be worth less every year, but your pay will also be worth less every year. If this is the case, then it may make sense to make extra payments and pay off your mortgage quicker. However, as mentioned above, you still may benefit from contributing the extra payments to a diversified stock portfolio instead of paying down mortgage debt.
Your Mortgage is Stressing You Out
If your mortgage debt and the monthly payments are stressing you out and causing you to sleep poorly at night then you should make extra payments toward your mortgage. Your well-being and health are much more important than maximizing your net worth at all costs!
The decision to pay extra toward your mortgage is a very personalized decision based on many factors including your goals, values, risk tolerance, cash reserves, other debts, and retirement timeline. This blog presents just a few important items to consider when thinking through your mortgage payments. As always, it’s best to speak to a financial professional who can help you with your specific situation.