If you own a home, chances are the single greatest expense in your life is your mortgage. Around 44% of American adults have a mortgage, and the average mortgage balance is currently sitting well above the $200,000 mark.
When you really sit down and crunch the numbers, it all adds up pretty quickly.
Let’s say you buy a $400,000 house and put down 20%. That leaves you with a mortgage of $320,000 — and on a fixed interest rate of 3.5% over 30 years, it means you’re going to need to pay an extra $197,299.48 worth of interest. That brings your grand total to $517,299.48 for a house you bought for $400,000.
Toss in property taxes, homeowners insurance, closing costs, mortgage insurance, and homeowners' association dues, and you’re looking at thousands more.
These colossal added expenses are why a lot of people aspire to pay off their mortgages early if possible. But believe it or not, a lot of times, it makes more financial sense to hold on to your mortgage and invest your extra cash instead.
That being said, there's no one-size-fits-all solution where mortgages are concerned. We'll explain why.
This guide explores how a mortgage works, the disadvantages of paying off a mortgage early, and whether it’s better to pay off your debt first or start investing now.
Before we break down whether it’s better to pay off a mortgage early or invest, let’s take a step back and cover what a mortgage is and how it works.
Simply put, a mortgage is a loan that enables one or more borrowers to purchase property.
After all the legal documents have been signed as part of the mortgage closing process, the borrower then receives a pre-agreed-upon sum of money to help them purchase the property. In taking that cash and signing their loan documents, the borrower then agrees to repay the lender a monthly mortgage payment until the loan is paid in full.
Lenders offer a variety of mortgage types and loan terms. But generally speaking, most mortgages run for a term of between 15 years anywhere up to a 30-year fixed mortgage.
It’s also important to note how a mortgage payment is composed.
Your average monthly mortgage repayments include two amounts: your interest and principal amount. Interest is the additional amount your bank charges in exchange for the privilege of getting to borrow the money. Meanwhile, your monthly principal is the amount of money required to pay down the total outstanding balance.
Now that we’ve covered how a mortgage works, you’ll understand why many individuals would consider overpaying their mortgage or trying to repay their outstanding balance early.
In 2020, the average individual mortgage debt was sitting at $208,185 — which represents a climb of more than $20,000 over the course of just ten years.
Translation: property prices are going up in a lot of places, which means mortgages are getting more expensive, too.
At first glance, it makes a lot of sense that you’d want to shed that liability as quickly as possible. But if you zoom in for a bit more context, there are quite a few downsides to overpaying a mortgage.
Let’s break those disadvantages down.
One of the key benefits you can expect to gain by maintaining a mortgage is the IRS mortgage interest deduction.
The IRS mortgage interest deduction is an IRS tax benefit that lets you write the mortgage interest on either a first or second home off your total tax liability. This can represent sizable tax savings for a lot of families — which means if you repay your mortgage early, you’ll miss out on that deductible.
By far, the biggest downside to paying off your mortgage early is that it’ll reduce your overall asset liquidity. Without liquidity, you could be left cash poor with limited access to money — which means if you eat into your savings to pay off your mortgage, you might not have any cash left to invest elsewhere.
Once your mortgage is paid off, financial experts say you should then consider opening a home equity line of credit.
What is a home equity line of credit? It’s essentially just a simple financial product that enables you to borrow against the available equity in your property. Your home is then used as collateral to support that line of credit, which gives you access to cash if you ever need it.
Then again, by keeping your mortgage, you’ll be able to maintain your existing liquidity levels. That extra money can then be saved for an emergency fund or invested in a nest egg for future generations.
Another reason not to pay off your mortgage early is that you may end up getting saddled with a penalty fee. A lot of banks will charge you a penalty fee if you overpay your mortgage past a certain monthly or annual capped amount.
Why do banks charge penalty fees on mortgages?
Simply put: to lenders, a mortgage is a financial product designed to generate profit. Everything in your initial mortgage offer is intricately priced to make sure that the bank makes a certain amount of profit by letting you borrow. That’s why lenders charge interest.
But if you overpay your mortgage, you’ll end up repaying it faster than your original mortgage term.
That means you’ll be paying less interest over the entire loan term — and so your lender won’t make as much profit. To protect those margins, your bank may enforce an early repayment or overpayment penalty to make sure your mortgage contract is still profitable from the bank’s point of view.
These penalties can sometimes be large enough to result in it not making financial sense to pay off your mortgage.
One point a lot of borrowers fail to consider when overpaying their mortgage is whether they could be making their money work harder by generating a higher rate of return elsewhere.
This consideration involves a pretty simple calculation.
If the rate of return on your investment assets looks like it'll be higher than the interest cost of your mortgage, you’re probably going to be better off financially keeping your mortgage.
Translation: by using the cash you would have spent paying down the debt to invest in an asset class with a high rate of return, you can make money and repay your mortgage simultaneously.
Normally when we talk about inflation, it’s a bad thing for consumers. But if you have a long-term liability with a fixed interest rate like a mortgage, inflation is your friend.
Here's why: when inflation rates go up, the fixed-interest rate financing you took out costs you less than when you took out the loan since the dollar has lost some of its value.
What does all of this mean for borrowers? It basically means you’re paying your lender back money that’s worth less than what it was when you took out the loan — and so you actually come out on top.
From the financial perspective of most investors, the answer to this question is “no.” Paying off a mortgage early isn't better than investing. But no two borrowers are 100% alike, and so what works for one family might not be ideal for the family next door.
Let’s walk through it.
Generally speaking, it's usually better to pay off your debts before you start investing.
This is because it frees up the drain on your finances that goes together with interest expenses. Theoretically, after you get rid of your debt liabilities, you're able to use your liquidity to make bigger and bolder investment choices without having to worry about overheads like debt repayment.
But mortgages can actually be an exception to this rule.
Unlike short-term debts like credit card debt you used to buy a new iPhone or a set of living room furniture, mortgages are long-term commitments. As we’ve already discussed, banks price each mortgage individually based on the assumption that the mortgage will be paid back over the full mortgage term.
In doing so, the bank will realize a profit margin on that mortgage product. In order to protect those margins, the bank often charges overpayment fees, which means it’s normally more cost-effective for customers to stick to planned payments for the full term of the agreement.
As a result, it generally makes sense for a lot of families to use any surplus cash they have to invest instead of trying to increase their monthly payment and pay down their mortgage faster.
After all, if you were to wait until your mortgage was repaid before you started investing, you‘d be dramatically limiting your time in the market — and one of the strengths of investing is putting compound interest to work for you by giving your money lots of time to grow.
Fortunately, there is a range of investment vehicles available to you that can help put your money to work right now.
One of the most popular investment options for an adult with children in their life is a UGMA custodial account.
A UGMA custodial account is designed to help an adult save for a child’s financial future — which means it’s an ideal way to invest if you’ve got small children.
The way it works is pretty straightforward. An adult sets up a UGMA account and names a child beneficiary. Every asset deposited into that account then becomes the legal property of the child. But because the child isn’t old enough to make their own financial decisions, the adult must serve as the account’s custodian until the child reaches the “age of majority.”
That age is different in each state, but it's normally either 18 or 21. When the beneficiary reaches the age of majority, they can use the assets however they want. It can help them pay for college tuition, travel the world on a gap year, or even as a house deposit to get onto the property ladder themselves.
But another reason a UGMA custodial account is ideal for a lot of families is that it offers a couple of tax benefits. Unlike other investment accounts, there are no contribution limits imposed on custodial accounts. That means you can gift up to your annual IRS Gift Tax exclusion (currently $16,000 per person per year) without paying any tax on that gift.
Likewise, because everything in a custodial account is the legal property of the child beneficiary, any unearned income the account generates through compound interest or dividends gets taxed at the child’s lower tax rate. This is called the “Kiddie Tax.” That could represent thousands of dollars in tax savings for some investors.
There are a couple of other popular investment account options you may want to explore, too.
For example, if you’re investing for your own future rather than a child’s future, a Roth individual retirement account (IRA) might be a good choice. A Roth IRA enables you to deposit cash that grows tax-free for your future retirement savings.
One caveat to bear in mind with a Roth IRA is that they normally have low contribution limits. Likewise, if you try to withdraw cash before you reach the age of retirement, you’ll need to pay a penalty and get taxed on your withdrawal for taking cash out that wasn't part of your retirement plan.
If you’re saving specifically with a child’s education in mind, you may also want to consider paying money into a 529 plan rather than overpaying your mortgage.
A 529 is an investment account and college savings plan that lets you deposit cash that can then grow tax-free until a child beneficiary needs that money to pay for college. This investment represents nice tax savings — but it’s important to bear in mind that most 529 plans have pretty strict rules about “qualified education expenses.”
That means you can only make withdrawals for certain things like tuition fees and on-campus accommodation. If you want to use cash from a child’s 529 plan to pay for stuff like travel or new gadgets to take to school, you’ll normally be penalized for your withdrawal.
Although paying off your mortgage early can be tempting, it’s important to consider every factor at play before settling your debt.
In some cases, it makes more sense to keep your mortgage and start investing simultaneously — and if you’re looking for a flexible way to build a nest egg for the kids in your life, a UGMA custodial account is a great place to start.
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