The Result is Often Psychological
You’ve got some extra cash lying around and you’re struggling with how best to use it. If you are like most people, you’ve probably given some thought to paying down your mortgage. Doing so gives many people a sense of security.
However, before taking this step, it is important to weigh several factors: How much money could you save over time? How much would that cash earn elsewhere? And will your lender assess an early payment penalty if you pay in advance?
Let’s Run Some Numbers
For borrowers with fixed rate mortgages, paying a little extra each month can reduce the amount of money owed on the principal and ultimately lower the amount of interest paid over the life of the loan. On a 30-year loan of $150,000 at 6.5 percent interest, a borrower who paid an additional $100 per month would save $51,725.18 in interest over the life of the loan. The loan would also be paid off six years and 11 months early. If the borrower paid an additional $200 per month, he would save $79,917.08 in interest and pay off the loan 11 years ahead of schedule.
However, this scenario doesn’t reflect the tax advantages of carrying a mortgage. While you end up paying less in interest when you prepay your mortgage, you also lose part of your mortgage interest tax break. Your true savings, then, can be expressed as the difference between your mortgage interest rate and the rate at which you take your deduction. If that net percentage figure is less than the amount you could make investing the cash, it doesn’t make financial sense to make extra payments towards your loan.
For example, assume the same scenario as above where the borrower pays an additional $100 per month towards the mortgage payment and cuts the interest by $51,725.18. What is the borrower’s rate of return? For someone in the 28 percent federal-tax bracket, prepaying a mortgage with a 6.5 percent interest rate provides a 4.68 percent after-tax rate of return. Now, if you could invest that same money somewhere and earn more than 4.68 percent, net of taxes, then you’re better off with the investment.
Also, if interest rates are rising dramatically, it doesn’t make sense to pay more on the mortgage. For example, if you have a fixed rate mortgage with an interest rate of 6 percent, and you can earn 8 percent in an interest-bearing account, it makes more sense to invest the cash instead paying down the mortgage.
If you decide to pay extra each month after crunching the numbers, you should stick with your existing loan and maintain flexibility rather than formally changing your contract with the lender from a monthly to a bi-weekly payment. Contact the lender first to let them know of your plans. That way, you can guarantee that the lender understands that any additional payments are to be applied to the loan’s principal balance. Otherwise, the lender might consider your extra payment as a partial prepayment for the next month.
Before adjusting your payment schedule, borrowers should carefully review their loan documents to assess whether they are subject to pre-payment penalties, which could negate the value of paying down the loan value. For example, a penalty of 3 percent on a $100,000 mortgage would equal $3,000.
In the end, the most important aspects of paying off a mortgage are often psychological and emotional, not financial. Many people like not being in debt. If paying off the mortgage satisfies an emotional need, then you may want to move forward even if it doesn’t make perfect financial sense. On the other hand, if it doesn’t bother you to be in debt — even during retirement — let the numbers make the call.
Patrick Sorter, Senior Loan Officer
Cole Taylor Mortgage