Why You Shouldn't Pay Off Your Mortgage Early, Even If You Can

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Sending in a monthly mortgage payment can be a hassle and a headache. It's probably your largest monthly payment, and it likely takes a good chunk out of your budget.

If you're tired of the bank being a co-owner on your home and want to stop sending in those payments every month, you may be tempted to try to pay off your mortgage early by sending in extra payments. Unfortunately, while it seems like a smart financial move, doing so can actually be a bad idea. Here's why.

1. There's a big opportunity cost to paying off your mortgage early.

Every dollar you put toward paying off your mortgage early 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 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.

Another opportunity cost is losing the chance to invest in the stock market. If you put all your extra cash toward a mortgage payoff, you're losing the chance to earn higher returns and benefit from compound growth by investing in the stock market. It's reasonable to expect around a 7% to 8% return if you invest in the broader market. Meanwhile, your mortgage rate is probably below 4.5% and may be much lower, so at most, you're likely getting a 4.5% return on any money you prepay to your mortgage.

You're better off doing something with your money that will most likely earn you close to double the return you'd get from paying off your home loan ahead of schedule. There's no pressure saying you have to beat your mortgage payment schedule.

2. You'll 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.

If you took out your mortgage before December 15, 2017, you're eligible to deduct the cost of mortgage interest you pay on up to $1 million in mortgage debt. If you took out your loan after, you can deduct mortgage interest on up to $750,000 of indebtedness.

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 401(k) 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.

If you spend $5,500 prepaying your mortgage instead of putting it into an IRA, you could miss out on a $1,210 tax break just from this alone if you're in the 22% tax bracket since you wouldn't have to pay the 22% tax on the $5,500 in income you deducted.

3. 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's better to get the guaranteed return that comes from mortgage prepayment, since there's 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'll 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 two 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'll likely earn better returns on your 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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