4 questions to ask before you pay off your mortgage

Paying off your mortgage before retirement may not be the best financial move.

Four key questions:

  • Can you afford to prepay your mortgage?
  • What will produce the greatest wealth?
  • When will you need your money?
  • How important is paying off debt to you emotionally?

Owning your home free and clear may sound awesome — no more checks to the bank, lower monthly expenses, the security and pride of knowing you own your house free and clear. In fact, for some people, paying off the mortgage may seem like a requirement before retirement.

But paying off a mortgage, particularly paying it down early, is a complex decision. Like most personal finance decisions, it's not just a math problem. There are emotional as well as financial factors to consider. What's right for one person might not be right for another.

What's right for you? Here are four questions to ask yourself to help decide.

1. Can you afford to prepay your mortgage?

Before you pay down your mortgage ahead of schedule, you need to make sure you aren't neglecting other important needs. For instance, if you have high interest credit cards, or higher interest short-term debt on a car, or a private student loan, you should look at paying off that debt before you consider paying off what may be a lower-interest-rate mortgage.

Also, if you have not taken full advantage of an IRA or 401(k), those savings options come with significant tax benefits, and maybe even an employer match. The tax benefits and match may make investing in these accounts more appealing than paying off low-interest rate debt, like a mortgage — particularly if you are concerned you won't have enough funds for retirement.

2. What will produce the greatest wealth?

If your goal is to end up with as much money as possible — for instance, to leave a legacy for charity or your children, paying off your mortgage early may not make the most sense.

Financially speaking, paying off your mortgage is equivalent to a guaranteed return at your mortgage interest rate. So, hypothetically, if you had $1,000 and used it to prepay a mortgage with a 3.5 percent interest rate, or invested it in a bond at 3.5 percent, the impact on your net worth would be the same either way.

Reality is a little more complex — you would likely have to pay taxes on the interest, dividends or investments gains earned from a portfolio. Meanwhile, the interest you pay on a mortgage may be tax deductible, so the actual equivalent interest rate may be slightly different. While everyone has slightly different tax situations, the lost tax deduction should offset the tax on your investments. As a hypothetical example, assuming a 25 percent income tax rate, a bond that nominally pays 3.5 percent may return approximately 2.6 percent after tax. While prepaying your mortgage would provide you with 3.5 percent interest savings minus the benefit of a tax deduction, resulting in a savings of approximately the same 2.6 percent.

For an investor, this raises an interesting question: Can you earn a better return on an investment portfolio? Since 1926, the average annualized return for a balanced portfolio of 50 percent stocks, 40 percent bonds, and 10 percent cash, has been 7.9 percent. That's far higher than most mortgages, even after accounting for taxes. For a growth portfolio (75 percent stocks, 20 percent bonds, 5 percent cash) the average annual return has been closer to 9 percent. Of course, past performance is not a guarantee of future results — the future return on an investment portfolio is uncertain. So your view of risk is important, as is your timeframe.

Let's take a look at a hypothetical example. Say Joan is 20 years into a 30-year mortgage with an interest rate of 4.5 percent, an outstanding balance close to $150,000, and a monthly payment of $1,500 a month. She just finished paying off her daughter's student loans, and has an extra $500 a month of discretionary income.

If she prepays her mortgage by an additional $500 a month, she will end up saving roughly $11,000 in interest payments and pay off her loan about 3 years sooner. Saving on interest is great, but she won't be able to claim the mortgage interest deduction on those payments that she avoided — that lost tax benefit offsets about $2,700 of savings. So in the end, she improves her financial situation by a little more than $8,200.

If she invests the $500 a month and she earns 8 percent a year over the same time period, she will end up with investment gains of about $14,400. After taxes, that would equal about $11,500, assuming an effective tax rate of 20 percent. The net effect: Compared with paying off her mortgage, investing improved her financial outcome by roughly $3,300, or roughly 40 percent more.

It is important to note that this hypothetical return roughly aligns with the historical performance of a balanced portfolio — but, in the future, actual returns could be lower or higher. What's more, a more conservative approach has historically earned a lower rate of return, so a risk-averse approach to investing makes the benefits of prepaying a mortgage more competitive relative to investing.

For illustration only. The hypothetical example does not reflect actual investment returns, and results may vary, including the risk of loss. This example assumes a 25 percent income tax bracket and a 20 percent effective capital gains tax rate.

3. When will you need your money?

Another key tradeoff between investing and pre-paying is liquidity. You can easily tap into a brokerage account to sell a bond or stock and use the money, though you have to accept market prices — and the volatility that comes with them — when you do it.

Further, prepaying your mortgage may make it more difficult to make use of your money. Tapping into savings in your home equity requires selling your home and moving, setting up a home equity line of credit, or possibly a reverse mortgage. Those options vary in complexity and cost, but in general, the investment account will be easier to access in the event you want or need to spend the money on short notice.

4. How important is paying off debt to you emotionally?

Fidelity research has shown that taking on debt can really weigh on a person's sense of wellbeing — for some, the burden is even greater than going through a major reorganization at work or other stressful life event. On the other hand, paying off debt can have a big positive impact, even more than a promotion or exercising.

If you are very conservative, the appeal of a guaranteed return on your money, and the security of knowing that your house is paid up, may have value beyond the dollars and cents involved. In that case, prepaying a mortgage may make more sense than the math would imply. Eliminating debt also reduces your monthly income needs, and that is another kind of flexibility.

The bottom line

There are some real benefits — both financial and emotional — to prepaying your mortgage. You reduce your total interest payments, you reduce your monthly spending needs, and you have the security of a guaranteed return and the psychological benefits of knowing you are out of debt.

You may also want to weigh the benefits of getting rid of debt against the opportunity presented by investing. Prepaying a mortgage may not produce as much total wealth as investing, and it also may make it harder to tap your assets in the event of an emergency or change in plans. It may be worth considering investing if you are more comfortable with risk, short on retirement savings, value flexibility or if your main goal is growing your wealth.

Find helpful guidance, tools, and services to assist you as you prepare for retirement on your terms. See more Fidelity Retirement Viewpoints.

Fidelity does not provide legal or tax advice. The information provided above is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific legal or tax situation.

Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. The opinions provided are not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.

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