Should you pay extra on your mortgage?

House on calculator

Owning your home free and clear has long been part of the American dream.

Paying off your mortgage early can help realize that dream, and today’s historically low interest rates mean putting a little extra into your home loan every month 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 adviser and PBS host, who believes paying off your home loan 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 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 13% 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 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.

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.

In fact, the stock market just finished its best year since 1997, with the Standard & Poor's 500, often used as a broad measure of market success, rising 26%.

But such investments come with risk. The last three years have been a good time to own stocks. But 2007 through 2009, were terrible.

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, or if you already have enough money in the market, and if the rest of your personal finances are in good shape, then this is the time to consider paying down your mortgage.

Most valuable home improvements for 2014Making your home bigger, or nicer, always makes it worth more. But some projects offer a better return than others. Let our 10 most valuable home improvements for 2014 help you decide what to tackle first. You’ll be surprised at how much of what you spend on these projects — from replacing the front door or adding a deck to finishing an attic or basement — can be recouped through a higher resale value.

That’s especially true if you've been putting money into more conservative options such as CDs and money market funds.

The best 5-year CDs currently pay only about 2%. Money market and traditional savings accounts will earn you even less.

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 a low-paying CDs or savings accounts.

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'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.

When he works with clients on retirement, “almost inevitably with a mortgage, there are going to be financial challenges,” he says, “while those that retire without a mortgage pretty much have clear sailing ahead.

“It’s that stark.”

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