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Should I pay off my mortgage faster by adding extra principal?

 

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Question:

I have been paying my mortgage for 5 years and now some extra income. Should I make additional principal payments? My mortgage is a 30-year fixed at 6.25% interest.

And how does the taxation play a role here? I am in the 25% tax bracket.


Answer:

If you prepay your mortgage or increase the monthly payment to pay of quicker, then your savings are 6.25% annually. What would you do with the money if you would NOT use it to pay down the mortgage?

You could put it in CD accounts which will yield maybe 4 to 5% interest. The benefit is that you are more flexible in case of an emergency (loss of job, health related bills).

There is zero risk in paying down the mortgage, and also zero risk in buying CD accounts, but the return of the mortgage is higher than the CD accounts.

If you buy stock, your risk is substantially higher. It is basically gambling. Your possible return is higher as well.
Investing in mutual funds on average yields 9% in the long term. However, in the short term, you may take losses. The risk is substantially lower than buying stock though.

The right decision also has to do with your age and your life, its schedule and what you expect to do in the future.

Taxation plays almost no role in the decision of whether to pay off early or invest otherwise.

Let's say you pay additional principal. That means you save interest in future payments. The interest is tax-deductible. So one could argue that the real cost of the loan is not 6.25% but 6.25% * 0.75 (since you are in the 25% tax bracket) = 4.7%

However, if your mutual fund yields 9% profit, you also pay 25% tax on that. So the effective profit is only 9% * 0.75 = 6.75%
Similarly a CD account yielding 4% effectively only returns 3% (4% * 0.75 = 3%)

The only exception is if your investment is pretax as a 401k plan or a tax-exempted bond. In that case you should compare the bond's full return against the prorated mortgage interest.

In your specific case - 6.25% is a pretty low rate. If you wait a little longer, you may find zero-risk investments such as savings accounts that will beat that return.


And now a completely different perspective on this topic:

If your mortgage is fully paid off, and your house gets hit by a hurricane or earthquake, then you are in more trouble than your neighbor who had only 10% equity in his place. You just lost all your house and try now to get money from the insurance. If the bank has the equity (and you have the mortgage) then the bank will deal with the insurance.

And there is also the thought that free and clear owners may more likely be subject to lawsuits if something happens to someone on your property. Not sure how relevant this is but I thought I should add it.


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Comments:

You are on page 2 of 5, other pages: 1 [2] 3 4 5
2007-09-15, 07:12:45
anonymous from Omaha, United States  
I hope I make sense. My biggest question is, where in the timeline of my mortgage does an extra principal payment apply? This is all hypothetical...but, say I just started a $100,000 mortgage. My payment is $1000 each month and I'm paying $100 in principal and $900 in interest. If I were to pay a $50,000 principal payment would it make my next payment ~$500 principal ~$500 interest or would it still be around $100 principal $900 interest.
2007-10-23, 20:34:23
[hidden] from United States  
rating
isn't it better to keep the money in savings, and then pay off one large sum? that way your money makes interest, but you still cut your loan short? so instead of paying $150 extra every month, why not just put the $150 into a savings account, and use that savings account to pay off the rest of your principal when the two are equal? this way you're making the 5% in savings + the 6.5% on cutting the years on the loan. no?
2007-11-07, 15:13:58
matt1999 from United States  
rating
Something else to consider, if you have a 30 year mortgage at 6% and pay extra each month you are making a 6% (risk-free) return that is tax free. You will not pay taxes on the money you saved. Any other investment you would be taxed on. Any other investment you may also need to pay brokerage fee's and are also taking a risk on the investment. You could loose money if you invested in a risky stock or whatever...

As far as the tax benefits by writing off your interest on the mortgage loan, compare how much you would save in interest compared to this write off. You probably save more by paying extra and reducing your interest payments than this tax benefit. My standard deduction is more than my interest on my home loan so I do not use it anyways...


2007-11-13, 01:45:21
anonymous from United States  
Is any familiar with how the TARDUS company from Honolulu teaches people to lower their mortgages from 30 years to 10 years or less?
2007-11-26, 08:07:10
anonymous from United States  
Re: the person paying the 3.4% 5 year fixed to be converted to ARM: if you're still undecided, I would save the money until the 5 years is up, and then make a large lump payment toward the principal before the next calculation. Because ARMs are recalculated (not the rate, obviously, but the amount you'll pay each month) based on the principal, the smaller that is, the less you will pay. Indeed, anyone in an ARM should pay down their principal as aggressively as possible. But until that point, it doesn't pay you to reduce the principal instead of saving that money in some interest-bearing or income-producing way.

Regarding the suggestion that one put the money in an interest-bearing account and simply pay off the mortgage early in one lump sum: you'd have to calculate the tax advantages (you pay taxes on the interest that you earn) but I agree that that makes sense. You would still reaThe problem is that many people don't have the discipline to leave that money untouched. On the other hand, in the case of an emergency like a catastrophic illness, it would save you from having to take out a home equity loan, because you'd have cash saved--and you wouldn't have to pay that additional interest on the second load.
2007-12-29, 17:39:01
anonymous from United States  
Hello, I refinanced my old loan for a ten year fixed interest only mortgage of $105,000 at 6.6% and my monthly mortgage is $804.33. I have been in this loan for one year now and I am thinking about making an extra monthly payment towards the prinicple. I am also selling within 2 years, How could making an additional payment help me out in the next 2 years?

thanks,
2008-02-19, 10:49:20   (updated: 2008-02-19, 10:53:04)
anonymous from United States  
Paying your Mortgage early, whether you see it to the end or just for a couple of years simply has the effect of giving you a return equal to the after tax rate on your mortgage (if you itemize, and the before tax rate if you dont')

or more cleary if you are in the 25% bracket and pay a 7% Mortgage, paying it off early is like saving at 5.25% pretax or 7% after tax. Most people can't get guranteed rates as good as paying off Mortg. But the point is to not keep getting and paying off Mortgages. You also need to consider liquidity and long term and short term savings.

It's very misleading to use the above example of paying $150 more per month and saying we save $X. we also 'lost' the potential investment dollars that $150 could have accumulated over time.

It's also incorrect to say it's best to save the payoff up in a savings account - well it's not wrong- but the poster seemed to imly that the math was better that way. It is,only if you save at a higher rate than your Mortgage interest, net of taxes - and you have discipline as noted.

If you are selling your house soon, paying more to principle will simply give you more back on your closing, and you'll effective earn your mortgage rate or mortgage rate*(1-Marginal tax rate). So it's not a bad thing.

Certainly, unless you have a upcoming balloon to refi or an ARM, I of course would focus on paying down Credit Card and Car debt, and accumulating a rainy day fund, etc, well ahead of paying down a mortgage. With all the programs to pay mortgage off sooner, though, it tends to be automatic and very satisfying. No doubt I'll do it if I get a mortgage in my late 40's as I 'assume' (lol) that will be my last house and I'll have the othre aspects in line, i.e. consumer debt and retirement savings
2008-04-16, 11:14:23
Matt1999 from United States  
rating
I would have to disagree with the comment above that states 'we also 'lost' the potential investment dollars that $150 could have accumulated over time.'

Your home is the investment. The nation wide average for home value increase is 6.5% per year. This would be your investment gain. It is not a sure thing and it is risky, just like the stock market or many other investments and it would be a long term investment.
The other factor relates to saving money by paying off your loan early so you do not pay interest to the bank.

Factor in these two investments when making a decision on whether you would be better off investing in something else.
2008-04-16, 17:32:54
anonymous from United States  
I was just preapproved for a 100,000 15 year loan. Payments are 1037. If I paid an extra 1000 a month how long would it take me to pay off the house.
2008-05-10, 03:16:10
anonymous from United States  
Matt, that is incorrect. The appreciation on your house is not relevant to the decision of whether to put cash in a savings or use it to pay down a loan. The house will continue to appreciate (hopefully) regardless of where you put your extra cash.

Also, with the constant increases in the standard tax deduction, the tax benefit of mortgage interest has disappeared for millions of home owners. If you're one of those who find all of a sudden that you don't itemize your deductions, then you are getting 0 tax benefit from your mortgage and this make paying down your mortgage an even more attractive option.

To apply this idea to the answer given above, the effective mortgage rate = the actual mortgage rate, while the effective risk-free savings rate is still the after-tax rate.
2008-05-20, 22:34:52   (updated: 2008-05-20, 23:34:48)
anonymous2  
rating
TRUE- The savings of putting EXTRA money into your mortgage is a NET gain of your mortgage rate or LESS your tax rate if you ITEMIZE. (anonymous gives a good example four threads above) So GET THIS NUMBER or % remember it and look for any alternative investments while also considering their tax implications +/-

Also consider: Self discipline, Volatility of current and potential income earnings, risk(on alternative investments), and timing of extra payments to principle/interest ratio on amortization.

2008-05-20, 23:45:45   (updated: 2008-05-20, 23:47:17)
anonymous2  
rating
TRUE- The savings of putting EXTRA money into your mortgage is a NET gain of your mortgage rate or LESS your tax rate IF YOU ITEMIZE. (anonymous gives a good example four threads above) So GET THIS NUMBER or % remember it and look for any alternative investments while also considering their tax implications +/- and risk.

Also consider: Self discipline, Volatility of current and potential income earnings, and timing of extra payments to principle/interest ratio on amortization.

2008-08-03, 22:34:16
anonymous from United States  
Has anyone ever heard of the 'Three Percent Rule' to pay off your 30 year mortgage in 15 years? Here's how it works: You make your regular monthly payments for the first year of the loan. At the beginning of the second year, you take an amount equal to three percent of the monthly principal and interest portion of your bill and include it as additional principal with each payment for that year. Repeat the procedure for each subsequent year, and in about 15 years you own your home. Now if you have heard of this would paying an amount equal to six percent cut the 15 years down to about 8 or 9 years? Thanks.
2008-08-06, 20:15:18
anonymous from United States  
So I have $69,200 left on my mortage at 5.5% interest and 14 years left of payments how much extra will I have to pay a month to have it payed up in 10 years.
2009-01-12, 13:09:50
anonymous from United States  
Why not use a form of interest cancellation?
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