Should you pay off your mortgage early? If you've come through the recent economic crisis in a position to be able to make additional payments on your home loan, this may sound like an attractive option. It's a safe, conservative financial strategy that many find appealing after being put through the financial wringer the past few years.

But it still may not be the smart thing to do. True, the practice of making double payments or otherwise paying a extra on one's mortgage each month was long considered a hallmark of sound financial planning. But that was a different era and today, what made sense in the past may no longer be your best course of action.

The reason for paying down your mortgage early, of course, is to save money. Making bigger payments now reduces the interest you'll have to pay over the life of the loan, perhaps by tens of thousands of dollars. It also moves up the date you'll own the home free and clear, and eliminating the monthly mortgage payment from your budget completely.

Mortgage tax benefits reduce effective savings

But how much are you actually saving? If you purchased or refinanced your home in the past few years, probably not much. Because mortgage interest is tax-deductable, it reduces the effective interest rate you're paying by about one-quarter. So if you're paying 6 percent interest, your effective rate is likely around 4.5 percent, perhaps lower.

What this means is that any additional money paid toward your mortgage is effectively earning you a return of 4.5 percent - money saved is money earned, literally. If you're in a higher tax bracket, the figure could be even lower.

The fact is, there are any number of fairly conservative investment approaches where you can earn a better than 4.5 percent return. Although the stock market took a big hit in 2008, the historic rate of return since the 1950s has averaged nearly 11 percent a year, including the recent downturn. Including bonds or investing in funds that include stocks and bonds can help even out the sharp peaks. If you're looking at an investment period of 20 years or more, investing will nearly always provide a better return.

This wasn't necessarily the case 20 or 30 years ago, when mortgage rates were running around 10 percent or even higher. Back then, paying down your mortgage as quickly as possible made much more sense.

Retirement saving, other needs may be more important

One of the other downsides of paying off your mortgage early is that it may distract you from other financial needs, such as saving for retirement. Paying off your mortgage early won't do you much good if you don't have a solid income to help you enjoy your home in your golden years - and most people don't save nearly enough.

An IRA or Roth IRA also offer tax advantages that effectively increase their earning power, just the opposite of what happens with the tax deductions on your mortgage interest, which effectively reduce the return you get on paying off your mortgage early.

Also, you shouldn't look to accelerate your mortgage payoff at the cost of personal savings. Most people don't have nearly enough of an emergency fund held in reserve and you can't count on being able to tap home equity if you need to in an emergency - such as if you lose your job, which will make your lender suddenly reluctant to extend you credit.

It's a good idea to have a savings reserve equal to six months' expenses, or at least three months, to tide you through emergencies. The fund doesn't even have to be in a savings account, you can have most of it tied up in mutual funds or other equities, provided that you can quickly convert them to cash if need be.

Refinance, retirement offer reasons to increase equity

There are two situations where it generally does make sense to pay down your mortgage early. The first is if you're looking to refinance and need to increase your equity stake in order to qualify. In that case, you're using a small amount to leverage a rate reduction on the entire loan, meaning you're getting a disproportionate rate of return on the smaller amount.

For example, if paying $20,000 allows you to refinance a $200,000 mortgage from 7 percent to 5 percent, that $20,000 could earn you as much as $260 month - the difference between the monthly payments on a 30-year fixed-rate loan at 5 percent versus 7 percent. That works out to a 15.6 percent return on investment.

The other time you may wish to consider accelerating your payoff is if you're approaching retirement and want to own your home free and clear. In that case, you may be looking at a relatively short timeline - say 10 years or less - that may make investing the money riskier than it would be for someone looking at a 20 or 30 year investing horizon. For homeowners in that situation, going into retirement without the burden of a mortgage payment can be a significant advantage.

Published on March 27, 2010