Instead of saving for college in a 529 plan, some families pay off their mortgage early to free up future cash flow. They plan to use the money previously spent on mortgage payments to pay for college.
Being debt-free may feel like an accomplishment, but it’s not always the best financial decision. Families should consider their mortgage interest rate, the liquidity of their assets and whether or not they plan to stay in their home before deciding to pay off their mortgage early.
Compare after-tax interest rates
Will you get a better return paying off your mortgage early or investing in a 529 plan? The answer depends on your interest rates. If the interest rate on your mortgage is very low, it may be better to save for college in a 529 plan that earns a higher rate of interest.
If you deduct mortgage interest from federal income taxes, be sure to look at your after-tax mortgage interest rate. Married couples are eligible to deduct mortgage interest on qualified home loans up to $750,000.
For example, a couple with a 4% mortgage interest rate who is in the 24% tax bracket who deducts their mortgage interest would have an after-tax mortgage interest rate of 3%.
1 – (0.24) = 0.76
0.76 * 0.04 = 0.0304
Historically, investors earned around 7% by investing in the stock market, adjusted for inflation. Funds saved in a 529 plan grow tax-deferred and can be withdrawn tax-free when used to pay for qualified education expenses. So, in this example the couple’s college savings will likely earn a greater return than what they would save on interest by paying off their mortgage early.
Consider your future plans
If your mortgage interest rate is higher than 7%, that doesn’t always mean you should pay your mortgage off early. If you have at least 20% equity in your home, it might make sense to refinance your mortgage for a lower interest rate and save for college in a 529 plan.
You will have to pay closing costs when you refinance, which are typically around 2% to 5% of your home’s purchase price. If your home appraises for $300,000 you can expect to pay between $6,000 and $15,000 in closing costs.
Families with no plans to move should be able to recoup their closing costs over time. To calculate your break-even point, divide the total closing costs by the amount you will save each month with your new mortgage payment. For example:
$10,000 in closing costs / $250 per month in savings = 40 months to break-even
When refinancing, it’s important to consider the rates and terms of your old mortgage versus your new mortgage:
- Interest rates on an adjustable rate mortgage (ARM) generally start out low but will fluctuate periodically based on interest rates of an index, such as the one-year Treasury bill.
- Refinancing to a longer loan term, such as going from a 15-year mortgage to a 30-year mortgage, may result in lower monthly payments but you will pay more in interest over time.
When calculating the break-even point, base the monthly savings on the reduction in interest paid, not the reduction in the monthly payment.
Home equity is not easily accessible
Paying off your mortgage early may be tempting since it will increase your net worth. However, money invested in a home is not a liquid asset and may be difficult to access later. If you don’t save for college and can’t afford tuition payments, you may not have the option to take out a home equity loan.
Taking out a home equity loan to pay for college was once a popular option because homeowners were able to deduct the interest up to $100,000. However, the Tax Cuts and Jobs Act of 2017 suspended the deduction for interest paid on home equity loans for any purpose other than home improvement until 2025.
Interest rates on a home equity loan are currently around 5% to 7%. There is also a chance that your home loses value and your home equity loan could put you under water. Most families would be better off saving for college in a 529 plan than taking a home equity loan, especially without the interest deduction.
The Federal Parent PLUS loan is an alternative to home equity loans. Current interest rates are around 7%, but up to $2,500 a year in interest may be deductible.
Avoid making an emotional decision
Paying off your mortgage early should be a decision based on facts and figures instead of emotions. You may like the idea of saving on interest, but are you certain that you will have available funds when it’s time to pay for college? College gets more expensive each year and could cost more than your mortgage by the time your child is 18. A smart goal is to aim to save one-third of future college costs and cover the remaining balance with current income and student loans.