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If you own real estate, you probably have a mortgage. If you own multiple pieces of real estate, you probably have multiple mortgages out.
For many homeowners and investments, a mortgage is a double-edged sword. On one hand, it multiplies your buying power and allows you to afford real estate that you otherwise wouldn't be able to consider. On the other hand, it often saddles you with debt for 30 years of your life, turning you into a payment-making serf.
Recognizing the interest they're paying and the amount of debt they're saddled with, many people become motivated to pay off their mortgages early.
While this can be beneficial, it's not always the best idea.
So when does it make sense to pay off a mortgage early?
The Scope of a Mortgage
Let's start with the basics of a mortgage. A mortgage is a home loan, generally provided by a bank, which provides people with the money they need to finance the purchase of a real property. Typically, banks demand a down payment from the buyer, at which point they'll supply the rest of the money necessary for the purchase. Mortgages are associated with an interest rate, which is often fixed, and a term, which is often 15 years or 30 years. Each month, you'll send the bank a payment for the principal and interest, and if you're in escrow, money for property taxes and insurance as well.
Throughout the duration of your mortgage, you'll be responsible for making significant monthly payments to the bank. You'll also have a gradually declining amount of debt attached to your name, often in the six or seven figures.
However, it's important to recognize that taking out a mortgage also equips you with a number of financial advantages, including investing with borrowed money, insulating yourself from inflation, and freeing up cash that you can use for other investments.
Why Pay Off a Mortgage Early?
Why would someone be motivated to pay off a mortgage early?
There are several legitimate advantages of this move:
· PMI elimination. Private mortgage insurance (PMI) is due in some mortgages; this is basically an extra fee you pay to the bank every month as compensation for the additional risk of carrying your mortgage. It's usually imposed on people who have made a down payment of less than 20 percent. If you prepay your mortgage to the point of exceeding 20 percent of the initial purchase price, you can generally waive PMI. This is a strong motivation for making additional payments on your mortgage, even if you don't plan on fully paying it off, as it allows you to save money every month.
· Interest rate elimination. Some people want to pay off their mortgages early so they no longer have to pay interest to the bank. If you take out a $400,000 loan with a 6 percent interest rate and a term of 30 years, you’ll end up paying more than $463,000 in interest alone – more than $863,000 to pay back the full mortgage. It's certainly reasonable to want to avoid paying $463,000 in interest to the bank, but as we'll see, this move doesn't always work in your favor.
· Debt elimination/avoidance. Debt has become a dirty word in our society, and for some valid reasons. It's generally a bad idea to rack up credit card debt and other forms of high-interest debt, and if you have too much debt attached to your name, you'll suffer from a declining credit score and fewer financial opportunities. Make no mistake: being thoughtful and diligent about your debt is a good thing. However, the desperate and relentless urge to eliminate all forms of debt, regardless of form, is usually a mistake. Unfortunately, many people simply pay off their mortgage because they see it as unacceptable. If your debt balance is too high and you're looking for ways to decrease it, you should probably focus on higher interest debt first. If you have too much financial leverage at the moment, it's reasonable to reduce some of your debt even if the interest rates are favorable. It all depends on your current financial situation overall.
· Monthly expense reduction. Paying a mortgage every month feels like a chore, and nobody likes to see this significant expense taken out of their bank accounts so consistently. Paying off the mortgage early means you'll never have to send these monthly payments again, but this advantage is mostly about convenience. You should also keep in mind that after you pay off your mortgage, you'll still be responsible for making regular payments on property taxes, insurance, and other home needs.
· Simplicity. Older folks are sometimes tempted to pay off their mortgage for more simplicity in their financial planning. If there's only a few years left on the mortgage, they might as well pay it off and have one fewer monthly expense to worry about.
· Autonomy and independence. If you have a mortgage, you'll be subject to certain responsibilities and requirements. As a simple example, you're typically required to have a homeowner’s insurance policy in place. Insurance is a good idea regardless of whether or not you have any standing mortgage, but some people are motivated to pay off that mortgage so they can have more autonomy and independence.
· Accomplishment. And of course, some people want to pay off their mortgage because it will give them a sense of accomplishment. Owning a house in full is certainly something to be proud of, but it doesn't always work out in your favor.
The Drawbacks of Paying Off a Mortgage Early
There are many significant drawbacks of paying off your mortgage early.
· Prepayment penalties. We'll start by acknowledging the possibility of prepayment penalties – in other words, penalties imposed on you by your bank if you pay off your mortgage prematurely. The Dodd-Frank Act generally prohibits this, but if your mortgage is an exception, these penalties may be imposed on you.
· Limitations on financial leverage. One of your greatest tools as an investor is financial leverage, or investing with borrowed money. It allows you to greatly expand your buying power, exposing you to assets and growth opportunities you wouldn't ordinarily have. Paying off your debt is a way of minimizing your financial leverage, limiting the benefits you can receive from this significant financial advantage. There's such a thing as using too much leverage, but if you're not using it at all, you're missing out on massive growth potential.
· Inflation woes. Debt can actually be a good thing in an inflationary society like ours. Inflation rises and falls, but it's always there in the background, weakening the buying power of the American dollar. Most people rightfully associate inflation with higher prices overall, but it's not about things getting more expensive; it's about the real value of the dollar getting smaller. If you've hoarded savings, or net positive wealth, inflation works against you; as the real value of our money decreases, so will the real value of your savings. But if you have debt, or net negative wealth, inflation works in your favor; as the real value of our money decreases, so will the real value of your debt. This isn't a good reason to rack up credit card debt or other high interest debt, as the interest rates usually far exceed whatever benefits you might get from tolerating inflation. But when it comes to mortgages with reasonable interest rates, it's often advantageous to hold your debt for as long as you can.
· Tax deduction loss. Remember that mortgage interest is tax deductible. You may not like the idea of paying interest to the bank every month, but you can at least write some of it off and reduce your tax burden as a result.
· Less liquidity. You’ll also lose liquidity by paying off your mortgage; in other words, more of your money will be tied up in an illiquid investment, depriving you of capital that you could use elsewhere. Investors typically benefit from having access to more liquidity, so they can invest in a wider range of assets more quickly and responsively. If your portfolio is already sufficiently liquid, this may not be a concern, but most people don't benefit from having a major portion of their wealth tied up in a single property.
· Opportunity costs. Finally, and perhaps most importantly, you need to think about opportunity costs. There are many investments capable of performing far better than whatever interest rate you're paying on your mortgage. If you pay off your mortgage prematurely, you'll deprive yourself of access to these investment opportunities. For example, let's say you've taken out a $400,000 loan with a 6 percent interest rate. The S&P 500 has, historically, returned about 10.4 percent interest annually on average. Assuming an investment here would return something similar, paying off your mortgage early means you'll no longer have $400,000 available to generate 10.4 percent interest every year. If you allow your mortgage to remain and you invest the $400,000, you'll still be paying 6 percent interest to the bank each year, but you’ll also be making 10.4 percent on that amount – essentially netting yourself a 4.4 percent interest rate gain each year. Why deprive yourself of this?
When Does It Make Sense to Pay Off a Mortgage Early?
Generally, it's better not to pay off your mortgage early, as long as you have favorable terms, but there are some situations when it does make sense to pay off your mortgage early. For example:
· You’re running the risk of overleveraging yourself. Leverage is a tricky thing to get right. When used responsibly, it can greatly increase your investing power with minimal risk. But if you go too deep into leveraged territory, you could introduce yourself to excessive risks and set yourself up for a powerful downward spiral if you're not careful. If you already have more debt than you're comfortable with, it might make sense to pay off a mortgage early – as long as you've taken care of all your higher interest debt first.
· You’re paying for PMI. If you're currently paying for private mortgage insurance, it's completely reasonable to prepay your mortgage until you no longer owe this. The degree of advantage you stand to gain here depends on how much you're paying for this insurance and how much it's going to cost you to avoid it.
· You have a high interest rate. If you have a high interest rate on your mortgage, you may not feel confident in securing a higher return elsewhere. Accordingly, one of the biggest advantages of maintaining your mortgage debt is going to dissolve. That said, a superior solution to a high mortgage interest rate is simply refinancing; for a fee, you can transfer your mortgage and get access to much better terms.
· You have more than enough cash for everything. Finally, if you're in such a strong financial position that you have more than enough cash to invest in anything you want, you won't have to worry about opportunity costs or liquidity issues. If you want to pay off your mortgage because it's simple, convenient, and makes you feel good, and you're not concerned about missing out on financial opportunities, go for it.
The Bottom Line
The bottom line here is that for most people, paying off a mortgage early is not a good idea. Not only does it deprive you of significant investing advantages like inflation mitigation and financial leverage, but it also precludes you from investing in superior assets and compromises your liquidity. That said, there are some circumstances where paying off a mortgage early is much more permissible, and potentially even advantageous. It all depends on your unique situation.
If you’re not sure what the best move for your real estate portfolio is, or if you just want more advice from seasoned investing experts, you’re in the right place. Our team of veteran real estate investors can help you with just about any goal you have – or any problem you need to solve.
If you’re ready to start the conversation, contact us today!
