Pitfalls of Paying Off Your Mortgage Early

Oct. 4, 2013 -- Should you pay off your mortgage? As with so many financial issues, the answer is: It depends.

A couple recently came to me for financial advice – after drastically changing their entire financial situation. They had attended a financial workshop where they became convinced that any debt is undesirable. So they paid off their mortgage early by cashing in their six-figure 401(k) accounts.

Because they were under age 59 1/2, they had to pay a 10 percent penalty, along with ordinary income tax, on this large withdrawal. They came to me – too late – for a second opinion on this by then irreversible move; the damage had already been done.

Whether to pay off your mortgage early is a difficult decision that should be based on various factors. Depending on your situation, some debt—especially mortgage debt--is probably not as bad as the alternatives. In this case, not paying off the mortgage would have meant keeping the couple's 401(k) assets intact and growing in value through compounding interest, which is interest on principal and interest. Albert Einstein famously called compound interest "the most powerful force in the universe."

Read More: Economists Explain Why Homebuyers Flock to 30-Year Fixed Rate Mortgage

This couple gave up their nest egg and its compounding interest to pay off a low-interest mortgage. Sure, they own the house now, but if they hadn't cashed in the 401(k) accounts, the home's value would be appreciating at the same rate regardless of whether it carried a mortgage. So they gained nothing in this respect, except for relieving themselves of the emotional burden that this relatively benign debt represented to them.

After digging deeper, I learned that they had real stress all right, but this stress stemmed not from having a low-interest mortgage, but from not having an overall financial plan. Paying off the mortgage gave them the emotional high of checking one thing off the list. However, they now have to sacrifice more to save money every month to fund their retirement.

If the couple's 401(k)s had been left intact to grow, it may more than double in value by retirement. The couple argued that not having the mortgage payment would free up money to save monthly. However, calculations show that they will likely have much less when they retire because they have given up the magic of compounding interest.

What's more, if they lose their jobs, they might have to sell the house, possibly for a low price if they're in a big hurry or the local real estate market is soft. Then, what's left of their home's value after real estate commissions and moving costs would go to pay living expenses – including apartment rent.

This tale serves as an extreme example of the principle that, while it's better to be free of debt, it's critical to take your financial circumstances into account.

Let's say you're in much better financial shape than this couple and you're considering paying off your mortgage just to be done with it. Unlike them, you won't have to touch your 401(k) to hold a mortgage-contract burning party.

Whether you should take this step – or even go part of the way by making multiple monthly mortgage payments -- depends on your circumstances regarding these factors:

• Your total financial picture. Have you fully funded your retirement, including uncovered health care costs?

• The amount of the mortgage payment. Is it so high that it's burdensome?