Mortgage payments are the biggest monthly expense for most homeowners.
It’s no wonder, then, that many people wonder if it makes sense to pay off your mortgage early.
While using savings to prepay the mortgage can ease a pretty heavy burden, it’s not a decision to be taken lightly.
Couples often ask us this when they sit down in front of us to put together a financial plan and it’s not just about the numbers. There is a nocturnal sleep factor that cannot be put into a spreadsheet or formula by which you can feel more secure with less or no debt. There is no right or wrong answer and everyone will have different motivations and goals.
Knowing what to do with a big lump sum or a little money is one of the most enjoyable financial problems to have.
Using the money to pay off your mortgage or investing – perhaps in stocks – are two options.
The first will save you money on your mortgage every month while the second option will give you the opportunity to build up a nest egg thanks to the returns generated by your investments. This could, for example, help finance a more comfortable retirement. Before you pay off your mortgage or start investing, you need to consider several factors.
Do you have emergency savings? It’s important to have a rainy day fund – cash on hand in case of a financial emergency. It can be anything from a broken boiler, to a big car repair bill, to losing your job. For these reasons, it is recommended to keep between three and six months of net salary in an instant access savings account.
Do you have other debts? You should also think about any other debts you may have, such as credit cards, overdrafts, or personal loans. The interest you will pay on these will likely be higher than the interest saved on your mortgage. The interest may also be higher than the returns you would get from investing. By paying off these debts, you can still give your overall finances a boost. This is because less of your monthly income is needed to cover repayments.
Do you contribute to a pension? If you are not already contributing to a pension, you most likely should. Contributions to retirement plans are tax-deferred, and if you have access to a workplace plan, your employer will also contribute, making it a very cost-effective way to save for retirement. It also represents a form of investment, albeit very long-term, as your money will flow through the financial markets and grow over time.
One of the main benefits of prepaying all or part of your mortgage loan is the reduction of your monthly expenses. This should then leave you with more disposable income monthly, which will open up options for you to save or contribute to your pension. You will of course reduce your overall interest bill to the bank or building society if you pay off your home loan sooner and pay much less interest than if you stick to the original term of the loan. However, there are downsides to putting your savings in the bank to pay off your mortgage.
One of the downsides of paying a lump sum prepayment on your mortgage is that once those savings are gone and put back in the bank, they’re gone for good. You will then have to rebuild that nest egg and of course, if you need an infusion of cash through a home improvement or a car loan, the bank will charge you a rate much higher than your mortgage rate.
Also consider the historically low mortgage rates that currently persist in the market. The mortgage debt you currently have is probably at one of the lowest interest rates ever seen for retail borrowers.
Of course, rates will likely rise to fight inflation in the years to come, but that won’t be significant for quite a while. It makes sense to consider your investment options of course where you could get an annual return of four or five percent.
The simple math here would suggest that this is a better use of your medium-term savings than giving it to the bank to write off a one or two percent debt. But of course it depends on each borrower and if you are comfortable investing your available money. Either way, the decision to pay off your mortgage in part or in full should not be taken lightly and all pros and cons should be discussed with an impartial financial adviser.