Pay Off Your Mortgage Sooner...or Later?

by Dianne Molvig

If you're a homeowner, it's only natural to long for the day when you'll own your house free and clear. To reach that day sooner, some homeowners accelerate their mortgage payments by paying extra toward the principal each month, once a year, or whenever they can afford it.

It's satisfying to see your mortgage balance shrink faster, and you'll shave thousands of dollars off the total interest you'll pay over the life of the mortgage. But is prepaying your mortgage a smart financial move? Often not, financial planners say.

"You have to look at what you're doing when you prepay a mortgage—you're investing in your house," says Sean Sebold, a certified financial planner® (CFP®) in Naperville, Ill., and a member of the Financial Planning Association (FPA). "Say I'm a broker who tells you I have a great investment for you. It earns maybe 4% a year. It's highly illiquid. And the transaction costs to sell it are ridiculously high. Would you want to buy it? Well, that's exactly what you're doing when you invest in your house."

Putting all or most of your extra cash into your house also runs counter to that longstanding guideline: Diversify your investments. "By prepaying, you're putting your money in the ground, and all you have is the appreciation of your house," points out Ricky Grunden, a CFP and FPA member in Denton, Texas. "You don't have a diversified portfolio."

Still, the desire to pay off your mortgage faster can exert a strong emotional pull. But before you give in to it, you need to ask yourself a few questions.

What's your mortgage interest rate?

Are you carrying credit card debt?

If so, put your extra money there before you even think about prepaying your mortgage. To get credit card debt under control, start by shifting to a pay-as-you-go strategy in your consumer purchases, Grunden suggests, so you don't accumulate new debts. Then make the minimum monthly payments on your credit cards while you build a small emergency reserve of $500 to $1,000.

"That gives people a better feeling about themselves," Grunden explains, "and inserts some discipline into their finances." Once you have the emergency fund in place, focus on paying off your credit card balances, starting with the one with the highest interest rate.

Are you saving and investing?

By spending your money on mortgage prepayment, you may be "leaving free money on the table," Grunden says. That's the result if paying more on your mortgage means you ignore investing in a 401(k) at work that has an employer match.

"I would argue that even before you start paying off your credit cards," he adds, "at least put the minimum in your 401(k) to get the matching. Think about it. If you put in 3% and you get a 3% match, that's a 100% return on your money."

Once you're putting the maximum into your 401(k) or other tax-deferred retirement plan, Grunden suggests you also may be able to invest in a Roth or traditional IRA, depending on your financial situation.

Let's say you've cleared away credit card debts and are growing your savings nicely. Now is it time to begin prepaying your mortgage? You could. But you may not want to, Grunden says. If you have a fixed low-rate mortgage, you'll be set with a fixed monthly payment that will become even a better deal with any ensuing years of inflation. You may benefit from the mortgage interest deduction on income taxes. And you'll have other investments earning money for you. "You're not going to create wealth by prepaying your home mortgage," Grunden says.

Are you committed to saving?

What's the nature of your cash flow?

Homeowners who have a sporadic income might be wise to avoid mortgage prepayment, Sebold advises. When you have extra cash, you may feel inclined to put it toward your mortgage. But if the cash flow ebbs later, you may be in a bind to meet your monthly payment.

"You can't say, 'Hey, I paid extra last month. Can I have that back?'" Sebold points out. "It doesn't work that way." So when you're feeling flush, use that spare money to build savings to get you through the down cycles in your income.

What's your risk tolerance?

Sure, you might sleep better today, he contends, but you may be setting yourself up for a nightmare later.

"You'll wake up one day and realize all you have is a house that's paid for that you can no longer afford to live in," he says. "I've seen older people who had their entire wealth tied up in their house. They had to sell and took a 15% haircut on it [because of falling home prices], plus they paid a 6% commission" to the selling agent.

Still, many people believe they must be mortgage-free by retirement. The common wisdom is that no one wants to face mortgage payments when they're no longer working. But Grunden recommends taking a different perspective.

"People are trained to think their financial life ends at 65," he says. "But your life expectancy doesn't end at 65, so your time horizon doesn't fold. You still want to focus on creating wealth."

It's difficult to set aside emotions when weighing whether to prepay your mortgage. Consulting an objective party such as a financial planner can be useful. Your credit union may offer financial planning services or be able to recommend someone.

If in the end you decide to prepay your mortgage, steer clear of the various lenders or other companies who will arrange that for you—for a fee. It's wasted money. You easily can do this on your own. If you need help devising a plan, your credit union loan officer will assist you with that, too.

Published July 21, 2008

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