Paying off the mortgage early has its benefits and even penalties. Find out more about the pros and cons of paying off mortgage early
On the surface, paying off your mortgage early may seem like the best thing you could do for yourself and for your lender. It proves that you prioritized your home loan and that you were financially responsible throughout. Plus, it means that you and your lender can terminate your contract early, enabling you to move on with your life and your lender to move onto the next customer.
While each of these things could be true, it is not necessarily your best financial move.
One reason is that most lenders will charge you a mortgage prepayment penalty, as an incentive to pay the home loan over the long term, which enables lenders to profit from the interest. Another reason you may want to reconsider paying off your mortgage early is that mortgages are a healthier debt than other higher-interest debts such as credit cards.
Before paying off your mortgage early, it is important that you understand the implications, the downsides, and the other areas where your money may be better spent. For the mortgage professionals who usually read our content, this is a good article to pass along to clients who have questions about paying off their mortgage early.
While it may be tempting to pay off your mortgage early—especially if you have the money to do so—there are downsides to consider as well. It may not necessarily be the right move for every homeowner. Here are three downsides to consider before paying off your mortgage early:
- Lost tax deduction
- Prepayment penalty
- Spending emergency savings
Let’s take a closer look at the downsides of paying off your mortgage early.
1. Lost tax deduction
If you are a homeowner, you have numerous tax advantages. One of the most significant is the mortgage interest deduction, which lets you write off the interest you pay on your home loan every year (if your balance is under $750,000).
However, if you pay off your mortgage early, you forgo this tax advantage. In fact, it may increase your taxable income considerably.
One thing to note is that the mortgage interest deduction is available only if you itemize your returns. Therefore, rather than itemizing, many homeowners opt for the more beneficial standard deduction. Depending on your tax filing status, the current standard deduction is between roughly $13,000 and $26,000.
2. Prepayment penalty
Another downside to paying off your mortgage early is the potential prepayment penalties. Because it eats into their ability to make a profit, lenders charge fees when you pay your mortgage off too early. While prepayment penalty fees can vary, most are a small percentage of the outstanding loan balance.
Typically, these penalties are charged if you are significantly early on in your mortgage term, such as the first few years, according to the Consumer Financial Protection Bureau. However, not every lender will charge prepayment penalties. It is therefore important to double-check with your lender if you are considering paying off your mortgage in full.
As you can see from the video, paying off your mortgage early has a lot of hot takes and competing views.
3. Spending emergency savings
While paying off your mortgage early may give you peace of mind, it could deplete your emergency savings, if you use all your reserve funds to pay off the home loan. If you have a sudden change in finances or lose your job, this could put you in a serious bind. Make sure you speak with a financial adviser if you are unsure whether paying off your mortgage early is the best move for you.
While it is important to know the risks before paying off your mortgage early, it is also important to weigh them against the benefits. Here are two benefits to paying off your mortgage early:
- Free up cash
- Save on long-term interest
Here is a closer look at the benefits of paying off your mortgage early.
1. Frees up cash
One of the biggest benefits is that it frees up a lot of money for you, since you no longer have the significant monthly payments to make. Instead, you can put that money into other investments, which have the potential to be higher earning. Over the long-term, this may mean even more money for you.
Freeing up money may also allow you to pay off other debts, which may be costing you a lot in interest. Think cred card debt, for instance. After all, the average credit card rate is currently more than 15%, according to the Federal Reserve. If this is your main motivation for paying off your mortgage early, however, you may want to consider refinancing.
2. Save on long-term interest
Paying off your mortgage early can save you a lot of money on interest costs, depending on your current balance and how much time you have remaining on your loan.
If, for example, you have a 30-year loan for $300,000 at 5% and, at year 20 (with a balance roughly $152,000), you receive a lump sum to pay off the remaining loan balance. If you had paid as planned, you would have accrued some $280,000 in total interest. If you paid off your mortgage 10 years early, your interest costs would be just over $238,000—representing a savings of over $40,000.
Some lenders will charge you a prepayment penalty if you pay off your mortgage early. The penalty is an incentive to pay back your principal over a longer period to allow lenders to collect interest.
Typically, you will not be charged prepayment penalties if you make extra mortgage payments or principal-only payments here or there. Lenders usually let you repay up to 20% of the balance of the home loan every year. Prepayment penalties are instead reserved for refinancing, selling, or paying off large amounts of the mortgage.
The reason for the mortgage prepayment penalty
The reason for the mortgage prepayment penalty is to alleviate some of the risk for lenders. Remember: The risk is significantly higher for lenders than it is for the borrowers in the first few years of the loan term, usually because most borrowers have not put down a significant amount of cash compared to the
property’s value. Paying your mortgage early means lenders miss out on the interest fees, which was an incentive for the lender to give the borrower the loan in the first place.
Most lenders offer the mortgage prepayment penalty to market lower interest rates. Lenders make this offer knowing they will recoup the difference over the life of the mortgage. If you pay the mortgage early, lenders recoup those same costs through the prepayment penalty.
Many mortgage lenders incentivize borrowers to avoid fully paying off their mortgages early. This usually comes in the form of a mortgage prepayment penalty. However, that is not the only incentive. Here are five reasons you should not fully pay off your mortgage:
- Tax break on interest 2. Home equity loan
- Higher returns elsewhere
- Other high-interest debt
- Emergency/retirement funds
Here is a breakdown of each of the reasons you should not fully pay off your mortgage.
1. Tax break on interest
Homeowners receive state and federal tax deductions on mortgage and home equity loan interest. This means that if you itemize your taxes, you can get a significant overall deduction.
If you got a mortgage that went into effect prior to December 15, 2017, you can deduct interest on loans up to $1 million. For any debt incurred prior to that date, however, you can only deduct interest on the first $750,000.
Regardless of when you got your mortgage, holding onto the loan longer will let you claim that deduction for the loan’s duration.
2. Home equity loan
If you have a mortgage, you will be able to take out a home equity line of credit (HELOC). And if that loan is used to buy, build, or improve a property, the interest you pay on the loan is deductible, according to the IRS. You will also be able to deduct the interest up to $750,000 on your mortgage and HELOC combined. Therefore, if you want to make a major renovation, it is in your best interest to hold onto that home loan.
3. Higher returns elsewhere
Repaying your mortgage early may mean that you do not have any money free to invest elsewhere, therefore limiting your potential for cash returns. One option for investing is to purchase rental property, rather than pay off your mortgage early. You will just need to make sure it makes the most sense for you financially. A mortgage calculator, mortgage pre-approval, and speaking with a mortgage professional can help.
4. Other high-interest debt
Compared to other forms of debt, a mortgage is comparatively cheap money to borrow. Therefore, it may make more sense to use any extra money you have to pay off more expensive debt, such as credit cards or any other high-interest debt.
One obvious reason is that a home loan usually has lower interest rates than credit cards, for example, meaning that paying off the high-interest debt first will save you significantly more money in the long run.
5. Emergency/retirement funds
Beware: Dipping into your emergency fund or retirement fund to pay off your mortgage early may give you a false sense of security. If you do not have money saved up, unexpected costs like necessary home repairs, emergency travel, or medical expenses might damage your financial standing.
After paying off your mortgage early, you may never get that money back. It can be especially difficult to secure a new loan when you most need it, particularly if it is on short notice. It is therefore recommended that you do not spend your retirement money unless you absolutely must. And know that it will cost you; because your retirement fund has not been taxed before, you will notice it once it’s taken out.
Yes. Paying off your mortgage early will likely hurt your credit score. However, that damage is usually negligible and short lived. For instance, it is likely that your credit score will drop 10 or so points after your mortgage is repaid. It does not compare to the money you would have to pay if you were late on your mortgage payments, for instance.
To better understand why paying off your mortgage early can damage your credit score, it is important to understand how credit scores are calculated. Here are five factors that determine your credit score:
- Payment history · Credit utilization ratio
- Credit history
- Credit accounts
- Credit mix, I.e., loan types
Your credit utilization ratio and your payment history are the most important factors here. And if you pay off your mortgage early, it could affect your credit mix as well as your credit history.
Your credit score may be damaged slightly if you do not have any long-standing accounts in your name besides your property loan and you repay your mortgage, resulting in a shorter credit history. Your credit mix may be damaged if by repaying your mortgage early you just have credit card accounts in your name. The reason is that credit card debt is viewed as an unhealthy debt compared to a mortgage. While paying off your mortgage early may only damage your credit score slightly, it may cost you more in the long run. After all, the prepayment penalties that most lenders will charge you will likely be significant. Plus, dipping into your emergency and/or retirement funds to repay your mortgage versus paying off other higher-interest debts could land you in financial peril.
Make sure you conduct your own research—and seek expert advice—before deciding if paying off your mortgage early is the best financial decision for you. A great place to start is our Best in Mortgage Special Reports page, featuring some of the brightest minds in mortgage for each country region we cover.
Do you have experience paying off your mortgage early? Let us know in the comment section below.