Deciding how best to allocate limited resources is always tricky. There are many ways to spend or invest your money, and only so much money to go around. So, when it comes to deciding whether to use that money to pay off a mortgage, you need to look carefully at all the possibilities.
In business, there is a concept called "opportunity cost." It means, once you spend money on one thing you can't spend it on something else. The opportunity cost is what you give up by spending it on your first choice rather than your next best choice. In this case, the opportunity cost would be what you have to give up to pay off the mortgage.
Identifying the Source of Funds
The first step in deciding whether to pay off a mortgage early is to determine where the funds will come from. Perhaps you just received an inheritance or legal settlement. Or, maybe you plan to pay off the mortgage gradually by paying extra toward the principal each month. Paying a little extra each month is often a good idea, unless money is extremely tight, because the opportunity cost is so small and the savings in interest is so large. Deciding whether to spend a lump sum on the mortgage is a more difficult decision.
Identifying the Opportunity Cost
The opportunity cost differs for everyone. One person might invest the money not spent on the mortgage in the stock market and earn 10 percent on that money. Another might only be able to earn 5 percent or even lose money. Someone else might spend the money on a boat or a vacation, or just put it in the bank earning .5 percent interest. These are all opportunity costs, and many involve value judgments just as much as they involve financial decisions.
Weighing the Cost
It is extremely difficult to weigh paying off the mortgage against taking a vacation because there are only intangible benefits to a vacation. In purely logical terms, there is no comparison. However, if we compare paying off a mortgage costing 5 percent to earning a guaranteed 10 percent in the stock market, the market would win. However, the key word there was "guaranteed." What if there was a 90 percent chance that you would make 10 percent, and a 10 percent chance that you would lose 50 percent? Once again, these are intangibles. The question is whether you are a gambler or risk averse.
It is important to weigh all the factors involved. In the previous case, paying off the mortgage is a guaranteed savings of 5 percent. Saving 5 percent is like earning 5 percent, except it is a sure thing with no risk of loss. Thus, if your mortgage costs 5 percent and you could make 5 percent in the stock market, the logical choice is to pay off the mortgage because there is less risk involved.
Consider the Other Factors
There are always other factors, such as personal preference and comfort. The major risk in paying off a mortgage early is you might need that money for an emergency. However, you can mitigate that with a home equity line of credit for use in an emergency. In the end, it boils down to what makes you comfortable. Almost any form of liquid investment has a risk of loss. With a paid-off house, you will have lower monthly expenses and always have a place to live, regardless of assigned paper value.
- Photo Credit Jeffrey Coolidge/Photodisc/Getty Images
How to Pay Off Credit Card Debt in a Lump Sum
Paying your credit card debt in a lump sum can be as easy as making a phone call. You have several options,...