Should you pay extra on your mortgage?
It’s a big part of the American dream — owning your home, free and clear.
Paying off your mortgage early can help realize that dream, and today’s low interest rates mean putting a little extra into your home loan every month could make more sense than ever.
Rather then letting money languish in a CD, money market or savings account making basically 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, bringing the day you own your house outright a lot closer.
Our accelerated mortgage payoff calculator can help you figure out how quickly you can pay off your loan and how much you'll save.
Before you start sending your spare cash to your mortgage company, however, 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
|Extra payment||Time shaved off loan||Interest payment saved|
|$100||4 years, 11 months||$25,014|
|$200||8 years, 4 months||$41,956|
|$300||10 years, 11 months||$54,261||Example: 30-year loan, 3.8% rate|
Here are three things you must do before paying extra on your loan:
Pay off high-interest credit card debt: You'll save a lot more by paying down credit card balances that often cost 15% or more than by paying extra on a home loan that carries a 4% or 5% interest rate.
Plus, you can usually deduct mortgage interest from your taxable income. Credit card interest is not tax-deductible.
Build up your emergency savings: Everyone needs at least six to nine 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.
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 longer-term options such as stocks could be greater than what you’ll save by paying down your home loan.
“If you had $5,000 in the (stock) market in the last three years, versus putting it into your mortgage, you came out ahead,” notes Pearson.
But such investments come with risk. The last three years have been a good time to own stocks. The three years before that were lousy.
You need to be willing to accept the ups and downs and stay in the market for the long haul to give things time to balance out.
If that’s not for you, and if the rest of your personal 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 and money market funds.
The average 5-year CD pays less than 1%. Money market and traditional savings accounts will earn you even less.
Of course, mortgage interest rates are also at record lows.
Even if you have a mortgage at 4% or a little less, paying extra on that loan could be a better use of your money than letting it languish in a low-paying savings vehicle.
Economists Gene Amromin of the Federal Reserve Bank of Chicago, Jennifer Huang of the University of Texas at Austin and Clemens Sialm of the University of Michigan recommend a simple way to decide if that is 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.
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.
Paying off your mortgage can make even more sense as you get closer to the years when you’ll be living on a fixed income.
Jonathan Pond, a financial adviser and PBS host, is a big advocate of freeing yourself from house debt before you reach retirement age.
"Paying off the mortgage could well reduce the amount of income you need in retirement by 20% or more," he writes in You Can Do It! The Boomer’s Guide to a Great Retirement.
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