Should you pay off your mortgage early?

There are 3 other savings goals that should get your attention first.

By MSN Money Partner May 19, 2011 1:00PM

This post comes from partner blog The Dough Roller.


Having recently paid off all of our non-mortgage debt, we now confront another financial decision: Should we begin to pay off our mortgage early?


Admittedly this is a good problem to have. But it does raise an important financial decision. We want to use our money in a way that produces the highest return with the lowest risk. And paying the mortgage off early may or may not help us meet this goal.


So as we make this decision, it's a good time to examine the issue thoroughly.


3 things that are more important

Before even thinking about paying off a mortgage early, there are three other financial goals that need to be satisfied:

  • Build an emergency fund. Having at least six months of expenses saved is a must before paying down a mortgage. In our case, I want a full year's worth of expenses stashed away in a savings account. The key is not to be cash poor as you pay down your mortgage. Otherwise, you could find yourself borrowing money at a much higher interest rate than your mortgage to handle an emergency.
  • Max out retirement accounts. Whether it is a company 401k, a self-directed IRA, or some other type of account, maxing out retirement savings is a priority over paying down your mortgage early. And retirement savings become even more important if your company matches a portion of your contributions.
  • Save for a child's education. If you have children and plan to pay for some or all of their college education, this should take priority over the mortgage too. Keep in mind that with many 529 plans, you also get tax advantages that you will want to take full advantage of.

Beyond the above three financial goals, it's worth asking yourself whether you'll have other needs for substantial cash over the next five to 10 years. For example, will you be paying for a wedding or planning an expensive vacation? If so, you'll want to cover these cash needs, too, before tackling the mortgage. Post continues after video.

Interest rates alone cannot answer the question

Once you've reached the point of paying down your mortgage, you still have to decide whether it's the best use of your extra cash. As a starting point, comparing the interest rate on your mortgage versus the interest rate you can earn on the money is a good idea.


You'll want to factor in the tax savings on a mortgage if you itemize your deductions. For example, we have a 30-year fixed-rate mortgage at 4.875%. Assuming a top tax bracket of 28%, our effective interest rate after taxes is about 3.5%).

The question now, however, is what we compare that interest rate with. If we compare it with current savings account rates, paying off the mortgage is a clear winner. Right now, the best rates on a savings account are just over 1%, and that's before taxes. The problem with this comparison, however, is that interest rates on savings accounts can, and likely will, rise. In contrast, the interest rate on my mortgage is fixed for 30 years. So I could end up throwing a lot of money at the mortgage now, only to see savings account rates hit 5% or more over the next five years.

Some like to compare mortgage rates with the historical returns of the stock market. If you can assume a long-term return of 6% to 8% from the stock market, it pays to invest rather than pay off a mortgage at a much lower rate. This approach has some validity, but you do need to recognize that you are comparing two options with very different risk profiles. Paying off a mortgage early has zero investment risk, whereas there is plenty of risk in the stock market, even over longer periods like 10 or 15 years.


In the end, comparing the rates of your mortgage and possible investment vehicles is helpful, but not conclusive.


Our approach

Regarding most things in life, my wife and I believe in a balanced approach. So rather than using every extra dime we have to pay off the mortgage early, we are taking a 50/50 approach. We've saved 12 months of expenses. We max out our retirement accounts and education accounts. And with whatever we have left over, we will put 50% toward the mortgage and 50% toward investments.


Our approach, of course, isn't the only one. Dave Ramsey advises to put everything toward paying down the mortgage. While that may be a perfectly valid approach for some, it's just too extreme for us.


If you are paying down your mortgage early, let us know how you've approached this issue.


More on The Dough Roller and MSN Money:


May 20, 2011 12:13PM
I paid off my mortgage in 2006 and am very glad that I did!  It is very comforting emotionally to have a paid for house when the stock market takes a dive (2008+), friends are getting foreclosed on because they lost their job and then their house, and every 1st of the month when I don't have to send the bank a payment!  This is my first time ever paying off a house and, as Dave Ramsey says, "the grass in the backyard just feels different under your toes when it's all paid for."  Yes, I have lost the opportunity to lose a lot of money in the stock market, uproot my family because the Sherrif comes a knocking, and oh, all those unused checks - what will I do?  I hope to never have a mortgage again!
May 20, 2011 10:15AM
We recently closed our money market account and paid off our mortgage.  For one, I'm not confident that we will see stock market returns in the 6 to 8 percent range, and as the article states, you have significant risk when owning stocks.  Second, interest rates on savings and likely even bond returns will not exceed our mortgage interest rates for many years. 

Yes, we still have about 18 months worth of expenses tucked away.  Yes, we fund our retirement accounts, though I view the mortgage payoff as a significant contributor to financial security in retirement.  And, a mortgage payoff has a known and guaranteed rate of return. 

So, with a guaranteed return of 5.4% on our mortgage payoff ..... it's a no-brainer. 

May 20, 2011 11:14AM
We paid an extra $900 a month on our mortgage until it was down enough to pay off with our emergency funds. After we paid it off we used the amount we were paying for the payment plus the $900 to refund our emergency account. Now that our emergency account has 2 years worth of expenses in it we now have an extra $2000 a month to save for kids education and retirement on top of our 401k's. Paying off our house was one of the best financial moves we have made. We have also paid our cabin off.
Feb 1, 2012 10:15PM
i have the money to pay off the house, but built a big garage with a apartment on top, 2 big rooms, open kitchen, dining and big bath, i rent my house to my son and wife, granddaughter, i make out pretty good. the money is in the bank if needed to pay off if the time comes, but for now, let the kid pay it, it is still like money in the bank., it is 750 bucks a month i don't spend and i save. if you can do smoething like this it works,WISH THEY HELPED A LITTLE MORE but what the hell. gives me something to do and bitch about. haha screw the stocks for now.
Feb 2, 2012 8:14AM
Back in the 90's when the banks were offering to transfer balances to a zero percent interest credit card without any fees, I took my equity loan and transfered it to seven zero percent interest credit cards. It took quite a bit of tracking but I am now debt free.
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