If you’re on a budget and want to enjoy retirement to its fullest, minimizing your home expenses is a good start. Paying off your mortgage prior to retirement is perhaps an even better one. This post will cover when you should (and shouldn’t) pay off your mortgage early.

What to consider before deciding to pay off your mortgage early

Before you consider your options, you’ll first need to determine if your mortgage lender charges prepayment penalties: fees some lenders charge for selling, refinancing, or paying off your mortgage early. A substantial prepayment penalty could sway your decision, especially if it’s equal to the amount you’d save in interest by paying off the mortgage early and/or will significantly impact your cash flow.

Speaking of cash flow, you’ll also need to calculate the overall impact of additional (or lump-sum) payments applied towards your mortgage. For starters, consider your emergency fund: which should cover, at a minimum, three to six months of living expenses. If your job isn’t stable and/or you have medical issues/uncertainty in your life (e.g., an unreliable car, a home dictating repairs, or are a single parent), your emergency fund should cover even more. This task is critical—you don’t want to end up “house rich” and “cash poor”—since your house is an illiquid asset. Therefore, if your emergency fund is lacking, you may not want to pay off your mortgage early. In addition to your emergency fund, you should also consider how the extra payment(s) will impact your lifestyle. If paying off your mortgage early will force you to make drastic changes, you may want to reconsider.

Reasons to consider paying off your mortgage early

To save on interest payments
Paying off your mortgage early will save you money on interest charges. This is especially true in the early years of your mortgage, during which you pay interest on a much higher balance. While you will lose out on any mortgage interest tax deductions, you may still save a considerable amount of money—depending on the size and term of your mortgage.

You’re paying a high interest rate
If your interest rate is relatively high and you don’t think you can earn much more by investing elsewhere, paying off your mortgage may make sense. While your mortgage rate would have to be fairly high to not invest your additional money (the S&P 500 averaged a 7.45% rate of return over the last 20 years), it really comes down to your own personal risk tolerance.

Peace of mind
Not every reason needs to make financial sense. For many, avoiding the burden of paying a mortgage can give you one less worry and increase your flexibility as you’ll inherently reduce your future monthly expenses. When you consider that housing is by far the largest expense for retiree households (representing almost 36% of annual expenditures), it’s easy to see why you’d want to minimize these costs.

Reasons why you may not want to pay off your mortgage early

You have debt with a higher interest rate
If you’re carrying other high-interest forms of debt—such as credit cards—it may make sense to put your extra money towards that debt instead of your mortgage. This is especially true when the rate of interest is higher in these cases. Doing so will likely help improve your credit score as you increase the amount of credit available to you when you pay down your credit card debt: lowering your credit utilization ratio, one of the biggest factors impacting your credit score.

You aren’t fully funding your retirement accounts
If you aren’t contributing enough to your 401(k), IRA, or other retirement accounts, funding these accounts should likely be your top priority. This is especially true if you aren’t—at a minimum—funding your 401(k) to capture all the free money offered to you by an employer match program.

You can earn more by investing
Let’s assume you want to allocate an extra $500 a month towards your $150,000 mortgage at 4% with 10 years remaining. In doing so, you would save over $9,500 in interest payments by paying off your mortgage. Alternatively, you can invest this $500 a month in an index fund that represents the S&P 500, which, again, averaged a 7.45% rate of return over the last 20 years. In this scenario, you can earn over $27,000 due to compound interest. Even a more modest return of 4.5% over the same time period can earn you over $15,000.

It is important to note that markets are sometimes volatile; therefore, the more time you have to ride out these market fluctuations, the more sense it makes to direct extra money towards investments.

To qualify for college financial aid
If you’re seeking out strategies to boost your child’s college financial aid eligibility, you may stumble across some bad advice online that recommends you pay off your mortgage with any extra assets you have—as home equity is excluded from financial aid calculations at institutions that only use FAFSA applications. The truth is that your assets have a limited effect on financial aid amount determinations (your family income is the primary driver). For example, the financial aid formula generally earmarks $5,000-10,000 held by parents as unavailable for college. Beyond this, parents are expected to contribute, at most, 6% of any additional assets each year. Therefore, for every $10,000 you have in the bank, the most you’d lose out on with respect to financial aid is $600: which, quite frankly, isn’t a lot of money (relatively speaking).

How to pay off your mortgage early

Let’s assume you have a $150,000 mortgage balance at 4% with 10 years remaining. The amount of interest you’d owe over the life of the remaining loan is $32,241. Here are some specific strategies to pay off your mortgage early and thus save money.

Bi-weekly payments
By switching from monthly to bi-weekly payments, you can save over $3,400 in interest over the life of the loan and pay off your mortgage almost a year earlier. Moreover, by adding a little extra to your bi-weekly payments, you can shave off even more interest and pay off your mortgage even sooner.

One extra payment per month
Based on the same assumptions noted above, making one extra payment a year can save you over $18,000 in interest—and you’ll pay off your mortgage over five years earlier!

One extra payment per year
Based on the same assumptions noted above, making one extra payment a year can save you $3,438 in interest—and you’ll pay off your mortgage almost one year earlier!

Refinance your mortgage
You should only refinance your mortgage to pay it off early when you can score a lower rate, a shorter mortgage term, and when refinancing fees aren’t cost-prohibitive.

Lump sum payments towards your principal
Another option to pay off your mortgage early is to make lump sum payments, especially when you receive an annual bonus. For example, if you make a $5,000 payment every year, you’ll save over $9,000 and shave off over two years from your term.

In sum: paying off your mortgage early

Should you pay off your mortgage early? There is no right or wrong answer here, as it really depends on how your mortgage expenses fit into your overall budget and how much risk you’re willing to take should you invest the extra money. However, if you want to enjoy high levels of flexibility during retirement, paying off your mortgage may make a lot of sense.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.