The Opportunity Costs of Paying Off Your Mortgage Early
A young family enters a property during an open house inspection in Sydney. (Photographer: Brendon Thorne/Bloomberg)

The Opportunity Costs of Paying Off Your Mortgage Early

BloombergOpinion

The housing market has been on a tear in the last year. New home sales reached a 14-year record, as the pandemic and incredibly low interest rates led to a buying frenzy. The trend is continuing into 2021 with the National Association of Realtors reporting 6.7 million new homes sold in the U.S. January, up 23% from a year ago.

As a new homeowner you may feel both accomplished and overwhelmed. But a six-figure mortgage doesn’t exactly make one feel “rich,” so perhaps you’re leaning into the popular financial advice of paying it down early. But is that always wise?

As one couple, Talaat and Tai McNeeley once shared with me, paying off their mortgage in five years afforded them more than just interest savings. It led to feeling financially empowered. “We didn’t want to owe anybody anything. It was about ... really controlling the elements of our financial journey that we could control.”        

It is a compelling argument, especially for those homeowners who get anxious about debt. In fact, a 2018 survey found about half of respondents were aiming to pay their mortgage ahead of schedule, and this was led by the 40-something demographic. 

I’ll admit, this is something that I have begun to prioritize in my current life stage. I’ve agreed to place more toward my principal with the hope of fully owning our home in 20 years, rather than 30. But there are opportunity costs to focusing so heavily on your mortgage. I strongly suggest doing so only after checking off a few other financial boxes first.

Bulk up rainy day savings. Before setting sights on mortgage zero, check your rainy day funds. Is there enough to cover basic expenses for several months in case you get laid off? The average “unemployment duration,” or the length of time it presumably takes for someone receiving unemployment insurance to begin a new job, is 26 weeks. Having at least a six-month savings cushion is ideal before putting extra toward your home loan.

Up your retirement contributions. It’s no secret that money in the stock market — over the long haul — offers a better return than paying down a mortgage with a 3% interest rate. The math speaks for itself. The S&P 500 has returned an average 8% percent annually over the last 30 years. Prioritizing retirement savings ahead of your mortgage just makes more financial sense.

Everyone’s retirement savings goal is different, but calculators like the ones here and here can help you determine if you need to contribute more to your 401(k) or IRA to stay on track. If you’re already contributing what you need to reach your goal and have more money to go around, you’re one step closer to having the means to pay down your mortgage sooner.

Contribute to a college savings plan. Investing in a 529 plan to help your child attend college with a smaller debt burden (or debt-free) may also be more financially rewarding than paying a mortgage off quickly. If you can manage to afford both without compromise, that’s fantastic. Go for it. But if your cash is limited, my advice is to go with funding the college savings plan ahead of making an extra mortgage payment. The logic here is, again, that the money compounding in the 529 plan will yield a higher return over time. And it will provide the added financial bonus of supporting a child through college. 

How much to contribute will be a factor of the type of school (public or private) you’re targeting, and whether you want to foot the whole bill or just part of it. A great new book to help parents navigate the cost is “The Price You Pay for College” by Ron Lieber.

Refinance and bank on lower rates. Finally, before settling on paying down your mortgage early, consider refinancing first. I realize this seems like a step in the opposite direction, since a refinancing “resets” the payoff clock, but hear me out.

With a top-notch credit score in the mid to high 700s, you may qualify for today’s ultra-low interest rate on a 30-year fixed rate mortgage, which is around 2.8%. If your current rate is closer to 4% and you plan to live in the home for many more years, refinancing may be worth it — more so if the monthly savings from a lower interest would eclipse any upfront closing costs in just a few years or less.

You can run your own calculations here to see if refinancing makes sense. If the answer is yes, then you could eventually take the monthly savings and apply it toward the principal to help you get out of debt sooner.

Bottom line: Paying down your mortgage early can reduce your interest burden over time, but it can come at the expense of other financial goals that offer more bang for your buck. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Farnoosh Torabi is a financial journalist, author and host of the "So Money" podcast.

©2021 Bloomberg L.P.

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