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?

• Other investments you may have. Depending on your cash flow, your financial plan and your ability to put money into it, paying off your mortgage may carry high opportunity costs–investment returns you'd have to forgo that might be higher than the interest rate on your mortgage.

• Your cash reserves. You should have enough cash to pay living expenses for six months squirreled away in the event of emergency – such as losing your job. If you don't have this, you shouldn't be thinking about paying off your mortgage.

• The interest rate on your mortgage loan. If this is a low rate – as most mortgages are currently after years of historically low rates – then you may not gain much by paying off your mortgage. While you're at it, you should evaluate this rate against the current lending market to see how much better you might do by refinancing your mortgage. Would this move produce a lower rate? If so, you might be able to lower your payment and invest more for retirement. This option might have helped the before mentioned couple.

• Property taxes on your home. Often, these taxes are included in the mortgage payments. (If not, you're probably acutely aware of this figure). If so, you want to determine this figure and account for it as a cost in your post-mortgage financial life. This figure tends to suppress the giddiness some feel when paying off their mortgage.

• Where you stand in the life of the loan. The more principal that's outstanding, the more interest you're paying. But the interest can usually be deducted for federal tax purposes. Have a look at your most recent tax return to estimate how much you're saving from this deduction. Again, this might make mortgage payments less painful and the thrill of outright ownership less alluring.

These factors represent the practical side of the decision of whether to pay off your mortgage. And while you should pay close attention to them, it's not imprudent to consider the impractical side of things – the satisfaction that paying it off might bring – assuming you're in good shape regarding the points above and that the payoff doesn't effectively cost you too much.

I once had a client nearing retirement with a $30,000 certificate of deposit maturing and $28,000 left on his mortgage. His retirement was fully funded, he had good cash reserves and had he always lived well within his means.

He came to me before making the decision and all but dared me to show him why it didn't make sense to pay off his mortgage. I could see that the psychological value of owning his home entirely was worth a lot to him. Since he had met all of his financial goals, I told him that, if it would give him satisfaction, then by all means go ahead and pay the darned thing off. Now he proudly displays his deed, framed and hanging on the wall.

This column is the opinion of the author and in no way reflects the opinion of ABC News.

Byron L. Studdard, a CERTIFIED FINANCIAL PLANNER™ practitioner, is founder and president of Studdard Financial, LLC, a financial advisory firm in Sarasota, Fla., dedicated to helping clients build wealth, protect it and pass it on to future generations. Studdard is listed in the Guide to America's Best Financial Planners (published by the Consumers' Research Council of America, an independent research organization). He can be reached at Byron@studdardfinancial.com. If you have a question for him, send him an email and he will try to answer it in an upcoming column.