If you are fortunate to have accumulated some cash and still have a mortgage, you may be wondering if it makes sense to pay off your mortgage or keep it. The benefits of living debt-free requires little explanation but paying off your mortgage doesn’t always make the best financial sense. Here are three situations when paying off your mortgage might not be the best option.
I’ll use all of my cash to pay off the mortgage
A mortgage balance is often a big number. If paying off your balance requires you to use up most or all of your free cash, this could cause a different problem—no emergency fund. The number one building block of financial stability is to have an emergency fund. This is a cash account at a bank or government money market fund that you never touch except in emergencies. If, for example, you use up all of your cash to payoff your mortgage and then your car dies or hot water heater goes, you may end up borrowing--possibly on a high interest rate credit card--to take care of that emergency.
Another important benefit of having a significant cash balance is the “sleep at night” factor. For many, having a good cash balance is like a warm blanket on a cold New England night. It provides you with security knowing that you can address whatever financial surprises may come your way.
I’m more than half-way through my mortgage
If you have a 15- or 30-year mortgage and you are more than half-way through the term, the financial benefit of paying of the mortgage is reduced. Mortgage lenders structure mortgages so that most of your payment in the early years is interest. In later years, most of the payment goes toward paying down the principal balance. Now you know why lenders love to refinance your mortgage—they get most of the interest up front, especially if you move or refinance before the end of the term of the loan!
So, paying off a 15-year mortgage in the 12th year doesn’t save you much in the way of eliminated interest payments. Besides, if you’re almost at the end of the mortgage term, it won’t be long before the mortgage is payoff anyway.
I’ll sell my investments to pay off the mortgage
There are two potential problems with this approach: 1) you may be earning more on your investments than the interest rate on your mortgage and 2) you may be subject to capital gains taxes on the sale of securities to pay off the loan. On the first point you should consider the trade off between payoff and potential investment gains. The basic rule is that if you believe you will earn more from your investments (after paying federal and state taxes) than the interest rate on your mortgage, financially it may make more sense to hold on to the mortgage and keep investing.
Remember that investment returns vary and there is no guarantee that your investments will consistently return more than your mortgage rate. If fact, you could lose money on your investments during the loan period. By contrast, paying off your mortgage will provide a guaranteed reduction in some amount of interest expense.
In addition, if you have to pay capital gains taxes in order to pay off the mortgage, you’ll need to take that into account in determining the tradeoff. In other words, you may have to earn significantly more than the mortgage rate in order to cover the cost of taxes.
Owning a home and having a mortgage is usually a long-term activity. And, depending on where you are with the term of your mortgage, current financial situation and short-term needs may mean a different approach than conventional financial wisdom.
If you have more questions about whether you should pay off your mortgage or not, give us a call. We’re here to help. You can schedule a quick call by clicking HERE.
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Lyman H. Jackson Lyman@PlanWithFPS.com
Financial Planning Solutions, LLC (FPS) is a Registered Investment Advisor. FPS provides this blog for informational and educational purposes only. Nothing in this blog should be considered investment, tax, or legal advice. FPS only renders personalized advice to each client after entering into an advisory relationship. Information herein includes opinions and forward-looking statements that may not come to pass. Information is derived from sources believed to be reliable. Information is at a point in time and subject to change without notice. Such information may not be independently verified by FPS. Please see important disclosures link at the bottom of this page.