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When to Pay Off Your Mortgage

A low-interest home loan may be worth keeping — or not

Jane Bryant Quinn: Should You Pay Off Your Mortgage?

Choose the best time to pay off your mortgage and free yourself from financial burden. — iSpot/Michael Austin

En español |My husband and I paid off our mortgage years ago. We planned to burn it while toasting our achievement with champagne. But we couldn't get our bank to produce a burnable piece of paper. It filed a document with the county, releasing its claim on our home, and that was that.

Burn the mortgage? What kind of 1950s world had we been living in?

Today, some financial planners say that homeowners shouldn't prepay, even if they can. Interest rates are so low, they say, you can get richer by keeping the loan and investing spare money somewhere else. Fixed 30-year mortgage rates average 4.2 percent, at this writing, and the interest is tax-deductible. Five-year adjustable-rate mortgages run around 3.1 percent. Long-term investors in stock-owning mutual funds hope to earn far greater returns.

Mortgage debt has become much more of a worry than it used to be for people in middle and older age. More than half of the households headed by someone age 55 to 64 carried debt secured by their homes in 2010, according to the Federal Reserve's latest Survey of Consumer Finances. That's up 45 percent over the past two decades. Among those 65 to 74, almost 41 percent carried home loans — up 87 percent. Monthly payments get harder to make after your paycheck stops.

So what's the best decision? Use any spare money to reduce your mortgage debt? Or use it to bulk up your savings, in hopes of retiring with more spendable wealth? The best choice depends on your circumstances. Here are some guidelines to help you decide:

If you're carrying credit card debt, pay that off first. It saves you much more money than prepaying your mortgage, and interest on consumer debt isn't tax-deductible.

If you're working, add your extra dollars to tax-favored retirement accounts such as IRAs or 401(k)s. Traditional accounts give you a current tax deduction, with earnings tax-deferred. Roth accounts let you accumulate your gains tax-free. And you can invest that money for long-term growth. Consider mortgage prepayments only after you've reached the maximum retirement contribution.

Don't prepay your mortgage with a lump sum of money taken out of an individual retirement account or 401(k). You'll owe income taxes on it, if you hold a traditional account. Withdrawing a large amount not only depletes your savings but might even bounce you into a higher tax bracket. You'd also lose the opportunity for those precious retirement savings to grow tax-deferred.

Don't leave yourself house-rich but cash-poor. At retirement, you want to be certain that you'll have enough income to cover your monthly bills. It's nice to be free of a mortgage when your paycheck stops, but not if you're so squeezed that you worry about having enough money for food and fuel.

If you sell your house for a substantial profit and downsize, consider buying the new place for cash. Provided, of course, that you have enough cash left over to live on comfortably. If needed, you can usually tap this home equity at a later date by getting a reverse mortgage. Reverse mortgages provide current income and don't have to be repaid until the last surviving homeowner dies or the house is sold.

Once you've paid off any consumer debt and funded your retirement account, it can make financial sense to invest extra savings in the market. But only if you're going to put a substantial amount of that money into stock-owning mutual funds. Historically, stock funds with dividends reinvested have done much better than the 4.5 percent you might be paying on your mortgage loans. You'll probably come out ahead.

It's another story, however, if you're keeping those savings in certificates of deposit, or in high-quality taxable bonds or bond mutual funds. At today's interest rates, prepaying the mortgage looks like a better deal.

Prepayments on a 4.5 percent loan give you a 4.5 percent return, guaranteed. (The return on any debt repayment always equals the interest rate.) After-tax yields on quality bonds and CDs are lower than 4.5 percent. Bond fund yields are lower, too. If interest rates rise, you can stop your mortgage prepayments and switch back to bonds.

Finally, here's the one argument in favor of mortgage prepayments that might trump everything else: gaining peace of mind. There's nothing like owning your own home, free and clear.

Jane Bryant Quinn is a personal finance expert and author of  Making the Most of Your Money NOW.

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