Living mortgage-free seems to be part of the American Dream. What homeowner hasn’t envisioned owning their home outright? Paying off your house is attainable over time, by taking a shorter term on your loan, or even by making extra principal payments monthly. What we’re talking about here is what to do if extra money becomes available as a windfall – an unexpected raise, a bonus, a tax refund, an inheritance. Should you extinguish the mortgage? Tread with caution … there are drawbacks you may not have considered.
Before you pay off that tax-friendly loan, first determine what you would be losing. With interest rates on 30-year loans below 4 percent, home loans are the cheapest leverage you will ever have. They may also offer significant benefits in the form of tax deductions, since any interest you pay becomes a write off, helping to lower the cost of the loan further still.
Have you reached all your other financial goals? Your top priority should be putting away enough money for retirement. If your employer offers a 401(k) plan, make sure you are contributing the maximum amount allowed. Use any unexpected money to cover your usual expenses so you can stash as many pre-tax dollars as possible in that 401(k). If your 401(k) contributions are already maximized, think about a traditional or Roth IRA.
If you are on track with your financial planning, congratulations! It may still be wise to explore other investment opportunities before you use a lump sum to pay off your home loan. If you have time on your side, you will likely do better in stocks or mutual funds. Over time, the market has historically done better than the 4 percent or so you can save by eradicating your mortgage.
What if you don’t want to or need to invest for the future? This point is nearest and dearest to my heart: Consider that once you pay off your house, that equity will be tied up and you’ve lost your liquidity. If an emergency arises, you may need to address borrowing against your house again. What if your financial picture changed and you couldn’t qualify for a loan?
So when would it make sense to pay off your home loan in full? If having a mortgage over your head keeps you awake at night or you’re about to retire, it may benefit you. After retirement, the tax perks may cease to be a factor. But beware of tapping your 401(k) to pay off the mortgage. Cash out early and you’ll owe federal and possible state income taxes on those earnings – in addition to a 10 percent withdrawal penalty if you are younger than 59 ½.