7 July, 2016 – Living without a mortgage is a tempting goal. By paying off your loan, you will not have that monthly mortgage payment squeezing your budget. You will own your home free and clear, and you’ll save thousands of dollars in interest.
But investing extra cash to pay off your mortgage early means you might not be able to meet other goals, such as saving for retirement or putting your child through college. Each option for investing your money has advantages and disadvantages, and you need to evaluate all of them when making this critical decision, according to J. Richard Price, CFP®, wealth advisor with Tompkins Financial Advisors.
Looking at Your Opportunity Cost
Before choosing whether you should pay off your mortgage early or put your money in other investments, you should determine your opportunity cost, or what you’ll gain financially by choosing one option against what you’ll give up.
One significant factor is the amount of interest you’ll save by paying off your mortgage early. Let’s say that you have a $300,000 balance and 20 years left on a 30-year mortgage, with an interest rate of 6.25%. By paying an extra $400 each month on your mortgage, you’d save about $62,000 in interest and pay off your loan nearly six years early.
While saving all that interest sounds appealing, you need to consider what you might be giving up by prepaying your mortgage, said Price. Do you have the opportunity to potentially profit even more from investing in stocks or bonds?
Consider the after-tax rate of return you can expect if you pay off your mortgage early. This is typically lower than the interest rate you’re paying on your mortgage, because of the tax deduction you receive for mortgage interest. Compare this figure to the after-tax return you could receive by investing your extra cash and determine which is higher.
It’s important to understand that the rate of return you’ll receive will depend on your choice of investments. Any investment comes with risk, and there is no guarantee that you’ll come out ahead. And investments with the potential for higher returns may expose you to more risk,
Beyond, the opportunity cost of paying off your mortgage, you’ll need to weigh a number of factors before making your decision. Here are some of the considerations you should evaluate:
Mortgage Specs – If you have a lower interest rate on your mortgage, there is a greater potential to earn a higher return through investing. Check whether your mortgage has a prepayment penalty, which could influence your decision.
Propensity to Invest – Consider whether you have the discipline to invest the extra cash rather than spend it. If you don’t, then it might make more sense to put your money into extra mortgage payments.
Financial Needs – Are there financial goals that would be difficult for you to meet if you paid off your mortgage? You may have other pressing financial concerns, such as high credit card debt. If you do, you should pay those obligations first, since consumer debt is often higher than your mortgage interest or the rate of return you’d receive on an investment. Remember that the interest on consumer debt is not tax deductible.
Time Horizon – The decision to pay off your mortgage will also depend on how long you plan to stay in your home. The key benefit of prepaying your mortgage is the amount of interest you’ll save, and if you plan to move soon, there’s less value in putting extra cash toward paying down your mortgage.
Tax Impact – Look at how paying off your mortgage will affect your overall tax situation. Prepaying your mortgage — and reducing your mortgage interest — could affect your ability to itemize deductions. This may be more of an issue in the early years of your mortgage, when homeowners are more likely to pay more in interest.
Retirement Savings – If you haven’t saved enough for retirement, you might consider investing the maximum allowable each year to tax-advantaged retirement accounts, rather than paying down your mortgage. This is critical if you’re receiving a generous employer match for your own contribution, which could add thousands of extra dollars to you retirement account each year.
Choosing the Middle Ground
There’s no reason why you can’t meet both goals of building up your investment portfolio while also paying down your mortgage. You can start by allocating part of your available cash toward one goal, and committing the rest toward the other. For example, by making a biweekly, rather than monthly, mortgage payment, you could potentially cut years off your mortgage.
Discuss your options with your financial advisor and your accountant before deciding on a strategy. And remember that it’s important to be flexible and reevaluate your goals later on as your circumstances and market conditions change.
Some of this material was prepared by Forefield/Broadridge for Tompkins Financial Advisors. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
We suggest that you discuss your specific situation with your financial advisor prior to investing.
Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.
Investing involves risk including loss of principal. No strategy assures success or protects against loss.
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