Why paying down your mortgage early is a bad idea

Are you thinking about paying down your mortgage early? Surprisingly, doing so is not always the smartest financial move.

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Why paying down your mortgage early is a bad idea
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Why paying down your mortgage early is a bad idea

The faster you pay off your mortgage, the faster you'll own your home, right? Right. However, according to some mortgage and finance experts, paying down your mortgage early may not always be the smartest option.

Why is that? Well, simply put, there is more to making a good decision than just looking at the financial calculations, according to Barry Habib, chief market strategist for Residential Finance, a nationwide mortgage lender based in Columbus, Ohio.

"While owning your home free and clear might help you sleep better at night, it doesn't always make sense to pay down your mortgage early - especially if you have a fixed-rate mortgage with a very low interest rate," Habib adds.

Curious to know when paying off your mortgage early might not be a good idea? Keep reading to find out.

Prepayment penalties may be involved

Did you know that paying your mortgage early could result in a fine? That's because some lenders "punish" you for getting out of your loan earlier than expected.

"A prepayment penalty is a provision that states that in the event you pay off the loan entirely, you will owe a penalty," explains John Walsh, president of Total Mortgages Services. Penalties are usually expressed as a percent of the outstanding balance at the time of prepayment, or a specified number of months of interest, Walsh adds.

Habib notes that while prepayment penalties are rare, they do exist - so homeowners should check their paperwork before they make a move.

Just how much can those penalties set you back? Habib says the penalties are all over the map and there's not one answer.

"It's usually a sliding scale that decreases as the years go on," he adds. For example, if you prepay within one year, there might be a 3 percent penalty; after two years, a 2.5 percent penalty, and so on until it goes away, Habib adds.

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You need to save for your retirement or your child's college fund

Have you checked your retirement accounts lately? If not, it might be a good idea to see how much you have saved up for retirement before you decide to pay your mortgage early, according to Walsh.

In addition to ensuring that you're financially set after retirement, making contributions to retirement plans - like IRAs and 401(k)s - instead of paying off a mortgage early, is smart because the interest they earn is not taxed until you retire, says Walsh. What's more, borrowers are able to deduct mortgage interest from their income, so when they put extra cash into an IRA or 401(k), it's a huge tax deduction all around.

Plus, if your company has a matching program, when you contribute to your 401(k), you're essentially getting free money toward your retirement. A matching program, according to the U.S. Department of Labor, is when employees contribute a predetermined portion of earnings to their 401(k), and their employer matches either all or part of that contribution. When you add up the amount your company matches over the years - the long-term benefits of adding money to your retirement accounts could be more beneficial than paying off your mortgage early, according to Hollensteiner.

But while your retirement accounts might be the most obvious way to save money, don't discount other options, such as putting money away in a 529 plan - which helps you save money for your children's college education.

According to Walsh, 529 contributions are tax-deferred, just like a retirement plan - which means you don't have to pay federal taxes on any money put away on a 529 plan. As a result, "a 529 plan can provide a very easy hands-off way to save for college," Walsh says.

Paying off your mortgage has tax implications

It sounds strange that paying off your mortgage early can cost you in the long run, but it certainly can be the case when taxes are involved.

For example, there's also a lesser-known tax in some jurisdictions, called a "Mortgage Recording Tax" (MRT) that some homeowners may have to pay twice if they pay off their mortgage early, according to David Reiss, professor of Law at Brooklyn Law School.

Before we get into how, here's some background on the MRT:

The MRT is a fee payable upon recording a mortgage with the county recorder or clerk, explains Reiss. "The fee is typically a percentage of the principal amount of the mortgage," he says.

In New York City, for example, the fee is a basic tax of 50 cents per every $100 of mortgage debt, plus additional fees based on the amount of your mortgage loan, according to The New York State Department of Taxation and Finance's website. So, on a $500,000 mortgage, for example, the MRT is $10,845, which includes basic and city taxes, among other things.

So how can you end up paying the MRT twice? Well, let's say that you decide to pay off your mortgage as quickly as possible. Then, you suddenly need a large amount of cash, and decide to access some of your home equity through a cash-out refinance. In this case, the MRT would be due a second time, Reiss explains. That's because under New York law, the MRT must be paid when a new mortgage is created and recorded on a property (as is the case with a refinance).

So, if you think you might need to access home equity in the near future (to pay for college bills or a home renovation, for example), focus on saving money for that particular purpose instead of paying down your mortgage early, says Reiss.

You could invest the money elsewhere for a better ROI

If your investment accounts are non-existent, it might be wise to grow them with the money you would otherwise use to pay off your mortgage early, according to Walsh.

Walsh offers this example to illustrate his point: Let's say you have a 30-year fixed-rate mortgage for $150,000, at 3.5 percent interest. "Your payments over the life of the loan will total $242,484 - with $92,484 of that being interest," Walsh says.

Although those numbers sound scary - investing the money could still make sense, depending on what the returns are. For example, if you invested the $150,000 in mutual funds at 6 percent returns annually, you will end up with $861,523 at the end of 30 years.

"That's $711,523 in profit," Walsh says.

And since your total interest payments on your 30-year mortgage will be only $92,484, you now have a huge amount of money in your pocket.

"By keeping the mortgage and investing conservatively, you end up ten times ahead," Walsh says.

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