When Should You Pay Off Your Mortgage Early?

In today’s low-interest-rate environment, where 30-year mortgages can be found for around 3.2%, it gets much harder to justify paying off a mortgage early. After all, you’re borrowing money at less than recent inflation, which makes it cheaper than free when measured versus the deteriorating purchasing power of your money. In addition, with the stock market’s historical long-term returns somewhere around 10% annualized, you have a decent chance of beating your borrowing costs by investing.

That combination makes it very tough to financially justify paying off your mortgage early. Still, there are a handful of reasons it might still make sense to retire that bill ahead of schedule anyway. Read on for five situations when you should pay off your mortgage early.

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No. 1: If you’re trying to qualify for college financial aid

Colleges generally use one of two different sets of formulas for determining how much aid students qualify for. If they base their decisions on the Free Application for Federal Student Aid (FAFSA) process, equity in your primary home is not considered as an available asset to pay for college. Colleges that use the CSS profile, on the other hand, may consider home equity as an available asset to pay the bill, but not all do.

If you assume you have a $400,000 house with a $250,000 mortgage balance and $250,000 worth of after-tax investments, schools that use FAFSA see those $250,000 of investments as available. If, on the other hand, you take those investments and pay off your mortgage, your net worth doesn’t change, but schools that use FAFSA no longer see that pot of investment money as available to pay for school.

Especially if you have more than one child for whom college is approaching soon, the benefit of lower out of pocket college costs might very well outweigh the returns from keeping that money invested.

No. 2: If you’re trying to qualify for an income-based subsidy

If you have control over your income (such as if you run your own small business or are retired early and living off your investments), you might find it beneficial to keep your reported income low. For instance, if you get your health insurance through the Affordable Care Act, your out of pocket insurance premiums are based on your income level. The lower your income, the lower your insurance costs will be.

By paying off your mortgage, your cash flow needs can be reduced substantially. If that enables you to keep your income down, the savings on your health insurance premiums over time could potentially outweigh the net returns you would get by investing while keeping a mortgage.

No. 3: If you’re retired and have five years or less to go on your mortgage

A good financial guideline to follow is that money you expect to spend within the next five years does not belong in stocks. If you’ll be living off your savings, your mortgage will be one of those bills you will have to cover. If you have five years or less left on your mortgage when you retire, that means you should have enough outside of your stock holdings to pay off your mortgage plus cover your other costs for five years.

Chances are good that your cash, CDs, and/or short-term bonds will not outperform your mortgage by enough to justify keeping your mortgage while holding on to that extra money. As a result, in that situation, paying off your mortgage sooner can still leave you financially better off versus holding on to it, even in today’s low interest rate environment.

No. 4: If you want to make aggressive Roth IRA rollovers

Rolling money into your Roth IRA from traditional retirement accounts can reduce your exposure to higher taxes and Medicare costs later in your retirement. The downside of rolling money into your Roth IRA is that you pay taxes in the year you make the conversion, generally at ordinary income tax rates. That makes such rollovers a complicated “pay me now, or pay me more later” type decision with a lot of moving parts.

As a general rule, Roth IRA rollovers make the most sense if you can use up low income tax brackets and if you can make the tax payments from your non-retirement assets. The lower your ongoing costs of living, the more of your available income and cash flow can be used to pay the conversion taxes. As a result, it could very well make sense to pay off your mortgage early to free up that much more money to cover those conversion taxes and boost your Roth IRA balance sooner.

No. 5: When you have ‘enough’, and peace of mind is important

If you’re on track or ahead of plan for your other life goals, there is really no need to keep to an overly aggressive financial plan. Even if you could potentially earn more money by keeping your mortgage and investing the money that could otherwise pay it off, there is no law that says you have to. Once your other goals are covered, it’s OK to stop playing the game of aggressive investing and use some of your hard-earned money to pay off your mortgage.

The peace of mind and improved monthly cash flows are legitimate benefits you will get from no longer having to make that substantial payment every month. When the market does crash again, you’ll certainly be able to rest that much easier in your completely paid off home.

When your mortgage is a tool rather than an obligation, you’re in a good spot

Regardless of where you end up on the decision to pay off your mortgage early or not, simply being able to do so puts you in a pretty good spot, financially speaking. So recognize that if you’re in a position where that is a possibility, what you’re really doing is optimizing between reasonable options, rather than choosing between a great and an awful idea.

Keep your total financial picture and asset allocation strategy in mind, and you can make a reasonable decision on how to proceed for yourself. No matter when you get around to paying it off, you’re certainly entitled to do a happy dance once your mortgage is gone. And if you can pay it off early in support of one of these five goals, then your happy dance can be all that much brighter.

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Chuck Saletta has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.