There are 3 big reasons, you should think twice before making extra mortgage payments.
Sending in your monthly mortgage payment can be a hassle and it’s probably your largest monthly payment that likely takes a good chunk out of your budget.
If you’re tired of your bank being a co-owner on your home, you may be tempted to try to pay off your mortgage early by sending in extra payments. While it seems like a smart financial move, doing so may not be such a great idea.
- There’s a big opportunity cost to paying off your mortgage early. Every dollar you put toward paying off your mortgage is a dollar you can’t use for anything else, such as saving up an emergency fund. If you have no emergency fund because you put your extra money toward an early mortgage payoff, a single financial disaster could force you to take out costly loans. Or, if your mortgage hasn’t been paid off in full yet, an emergency could lead to foreclosure on your house if it means you can’t pay the mortgage later. While you could tap into the equity in your home, using a home equity loan or line of credit to cover emergencies, getting these loans can be costly, time-consuming and you aren’t guaranteed to get it.
- You will miss out on tax breaks. If you itemize your taxes by taking specific deductions instead of claiming the standard deduction, you can deduct interest paid on your mortgage. When you deduct mortgage interest, this reduces your taxable income for the year, meaning you may pay a less percent of your income in taxes if you fall into a lower tax bracket. You give up that tax break each year after your mortgage is paid off. Plus, if you’re using money to pay your mortgage that you otherwise could’ve invested in a 401K or IRA, you’re also giving up a tax break each year you could’ve gotten for retirement savings. And you don’t have to itemize to claim these tax breaks for retirement investments, which means you can claim them even if you take the standard deduction.
- Inflation offsets savings in interest. Despite the fact you can earn better returns by investing than by paying off your mortgage early, some people still prefer to prepay their mortgage. This may be because of an aversion to debt, or a belief it is better to get the guaranteed return that comes from mortgage prepayment, since there is no guarantee invested money will grow.
The problem is, you need to factor in inflation when deciding if this strategy makes sense. Due to inflation, your mortgage effectively becomes cheaper to pay over time since the value of your money erodes but your mortgage payment stays the same (assuming you have a fixed-rate loan). If you have a monthly payment of $1,500 today, in 25 years, the $1,500 you will pay toward your mortgage would be the equivalent of around $942 of today’s dollars — assuming inflation of 2% annually.
Since your mortgage payment is continually getting cheaper over time, it seldom makes sense to prepay it. Don’t forget that all the interest savings you net from paying off the mortgage early are also reduced by inflation, making this even less of a good deal over time. If you save around $80,000 in interest by paying off a $300,000 4.5% mortgage in 21.5 years instead of 30 years, you’ve actually saved less than $50,000 when accounting for the fact you don’t benefit from the interest savings for more than 2 decades.
Consider investing instead of paying off your mortgage early. If you want to make the smartest choice for your money, putting it into the market and building a diversified portfolio is the way to go. Over time, you will likely earn better returns on you money, you will benefit from years of tax breaks, and the costs of your monthly mortgage payment will fall thanks to inflation.
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