Should you pay extra on your mortgage?

House on calculator

You've probably dreamed of the day when you finally send in your last mortgage check and own your home free and clear.

Paying a little extra every month on your home loan is a way to make that dream a reality faster than you thought, and with today's historically low savings rates, it could make more sense than ever.

Rather than letting money languish in a CD, money market or savings account that pays practically nothing, many homeowners might be better served by paying down their mortgage.

Doing so can save tens of thousands of dollars in interest and shave years off your loan. Our accelerated mortgage payoff calculator can help you figure out how quickly you can pay off your loan and how much you'll save.

"It can be life-changing," says Jonathan Pond, a financial author and adviser from Newton, Massachusetts, who believes paying off your mortgage early can be one of the smartest moves you can make, especially as you reach retirement.

But before you start sending your spare cash to your mortgage company, you need to make sure your overall finances are in order. Paying extra on your home loan isn't always the smartest use of your money.

"We look at the whole picture when trying to make that decision," says Diane Pearson, a certified financial planner and shareholder at Legend Financial Advisors in Pittsburgh.

Pay Extra on a $200,000 Mortgage and Save Big

Example: 30-year loan, 4.0% rate

Extra payment Time shaved off loan Interest payment saved
$100 4 years, 11 months $26,854
$200 8 years, 5 months $44,929
$300 11 years $58,009

 

Here are 3 things you must do before paying extra on your loan:

 

1. Pay off high-interest credit card debt.

With the average variable credit card interest rate around 16%, you'll save a lot more by paying down your card balances than by paying extra on a home loan that carries a 4% interest rate.

Plus, you can usually deduct mortgage interest from your taxable income. Credit card interest isn't tax-deductible.

2. Build up your emergency savings.

Everyone needs about six months of living expenses in a savings or money market account, where you can withdraw it quickly and without penalty.

Without that financial cushion, you could lose your home, including the extra money you worked so hard to put toward the balance, if you get laid off or become ill and can't work.

3. Contribute to your retirement plan.

If your employer matches all or part of your contributions to a 401(k) plan, make sure you're putting in enough to collect the full benefit.

Not taking advantage of matching retirement fund contributions is saying "no thanks" to free money.

If, for example, your employer matches 50% of your contribution up to 6% of your income, that's like getting a 3% pay raise and earning a 50% return on your investment.

Finally, you should consider whether the potential gains from investing the money in long-term options such as stocks could be greater than what you'll save by paying down your home loan.

Over the past 40 years, the S&P 500 — a broad measure of stock market performance — has delivered an annualized return of about 11%.

But 2016's early wild gyrations reminded us that you must be willing to stick with the market long enough for the inevitable ups and downs to deliver those profits.

If that's not for you, or if you already have enough money in stocks and the rest of your finances are in good shape, then this is the time to consider paying down your mortgage.

That's especially true if you've been putting money into more conservative options such as CDs, savings or money market accounts that pay less than 2%.

How much house can you afford?

This is the first thing you need to decide before you even begin to hunt for a new place to live. No one wants to be house-poor, saddled with mortgage payments that gobble up too much of their paycheck. Follow these 5 smart moves, and you'll find the price range that fits your budget.

Even if your mortgage costs 4% or less, paying extra on that loan could be a better use of your money than letting it languish in low-paying CDs or savings accounts.

Economists Gene Amromin of the Federal Reserve Bank of Chicago and Jennifer Huang and Clemens Sialm of the University of Texas at Austin recommend a simple way to decide if that's true:

Multiply your mortgage interest rate by 1 minus your tax rate. If the result is higher than what you typically earn with a conservative investment, pay down your home loan. Otherwise, the savings option is better.

Example: Say your interest rate is 4% and your tax rate is 25%: 1 minus 0.25 equals 0.75. Multiply 0.75 times 4% and the result is 3%. That's the real interest rate you're paying after taking into account the mortgage tax deduction.

If you're getting a rate of return higher than that, then you should leave your money where it is. If not, then putting the money into paying down that loan could be your best bet.

Some people think they should avoid paying off their home loan early to keep reaping the tax benefits that come with the mortgage deduction.

But Pond says, "The notion that you need a big mortgage to save taxes is absolute nonsense."

If you're in the 25% tax bracket and you pay $10,000 a year in principal, he notes, you reap a tax savings of $2,500: "So you're paying $10,000 to save $2,500."

You don't have to pay lots of fees to pay off your loan more quickly, either.

Our 3 free ways to pay extra will show you how.

Whatever method you choose, paying off the mortgage could well reduce the amount of income you need in retirement by 20% or more, Pond says.

"Almost inevitably with a mortgage, there are going to be financial challenges," he says about the clients he's advised, "while those that retire without a mortgage pretty much have clear sailing ahead.

"It's that stark."

  • Jen50

    Something doesn't look right. 30,000 owe at 3.6% .. taxes insurance in escrow stays the same. Make more than my principal payment. My principal keeps going up and interest is going down.. This is a fixed rate. very confused. yes it changes once a year due to escrow but not where they put my money each month. my principal started this past year started at 246.94. it is now 255.36 interest went from 91.39 to 82.97. I make 30.00 extra monthly payment. Why is my principal going up and interest going down on a fixed rate?

    • Carola Dryden

      That doesn't sound right. If you make additional payments and "state" that they are to be applied to the "principal only," then your principal amount should go down, not up. If you do not state that the additional amount is for "principal only", they either apply it at the same percentages as they do the regular payment or they may just apply it all to interest which looks like what they may be doing. Make sure that they are very clear that the extra amount you are paying is to go toward principal only. I payed $45 extra every month on my principal for my mortgage for three years and it made a huge difference in my principal balance.

      • Tami Ryan

        your principle is going up because thats the amount of your monthly payment going towards your principle and the lesser amount is going toward your interest - as it decreases your paying less toward interest.

        • Carola Dryden

          It doesn't make sense that her principal is going up. In the beginning of a mortgage loan practically all of your payment goes toward the interest and a very small amount goes to the principal. Even if all of the payment went to nothing but interest her principal should not be going up. The principal is the actual loan amount she applied for and that cannot go up.

          • Eden Ross

            https://uploads.disquscdn.com/images/16f71c54d4df5e98d8a87100d162f686f7575f61fae3248552a4717abe315ba1.png Principal should absolutely go up (in theory). At the beginning if you're paying 500 a month and 200 goes to principal and 300 goes to interest. Your goal should be for the principal to be higher than the interest. As your total loan amount goes down- so should your interest, but your payments are still 500. Because of this, the amount of your payment applied to principal will be higher and your loan snowballs even faster. You should check out Karl's Morgage Calculator to see how drastic extra payments can change your loan. It's free and you can input your numbers and change it and play around with the numbers.

          • Carola Dryden

            I am amazed not to mention confused. I do know that when I sent in extra money monthly on my principal my loan amount went down pretty quick. Thanks for the info.

          • Gynxz Wang

            that is how long term loans work (car, house, etc). You have a fixed TOTAL amount as principal and interest BUT the bank charges you a higher % of the interest in the beginning so, if you default on your loan, they got their part first and you still owe most of the principal.

            note: numbers are not real just used to express a general idea of how loans work.
            Example. Lets say you ask for $100,000 and they agree to lend that with a total of $50,000. Instead of having your payment be %33 interest and %66 principal... they start charging %99 interest and 1% principal. Why? so if you default or decide to pay it off in 10 years you still owe most of the debt since you mostly payed interest.

            As time goes by that proportion gets swapped. after the first year you are paying 90-10 then 80-20 and so on until you are almost exclusively paying principal.

            If you do payments directly to principal both, principal and interest, go down but the proportion stays relatively the same.

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