Why you shouldn’t pay down your mortgage faster
By Jonathan Fahey
The Associated Press
The impulse to pay off your mortgage more quickly than you need to is understandable, especially these days.
Interest rates are near historic lows, so it’s possible to replace a 30-year mortgage with a 15-year loan and still afford the monthly payments. Or, if you’ve already refinanced at a dirt cheap rate, you can take those savings and pay down your principal faster.
But the allure is more emotional than financial. Mortgage debt provides great financial flexibility, and paying it down fast probably isn’t the best way to grow your nest egg.
“Generally speaking, there’s no advantage to paying down a mortgage earlier than you need to,” says Greg McBride, senior financial analyst at Bankrate.com
That’s because the interest on mortgages is low, it helps lower your taxes, and paying less every month gives you chance to reinvest the savings in more productive ways. Among the better options: paying down higher-interest credit cards, or saving for retirement.
Start with rates on 30-year mortgages. The average rate is 3.66 percent, close to the lowest level since the 1950s.
But in reality you pay an even lower rate when factoring in tax breaks. The federal government gives borrowers a break by allowing them to deduct mortgage interest from their income. And if instead of using the extra cash to pay down your mortgage you put it in a tax-advantaged retirement fund like a 401(k), your taxes are reduced even further.
Jim Sharvin, a certified public accountant with the firm McDowell Dillon & Hunter in Torrance, Calif. says if you are thinking of paying down the principal of a mortgage more quickly than necessary — either by switching to a shorter-term loan or sending extra principal payments to the bank — consider first doing the following:
• Pay down all high-interest debt, like a credit card. It’s the first priority because it’s very expensive debt, and it has no tax or other financial benefit.
• Build a cash cushion to cover unexpected expenses or loss of income.
• Bolster your retirement savings by putting the maximum amount allowed by law into a tax-sheltered plan such as a 401(k), a 403(b), or IRA. This also reduces your taxes.
• Fund a college savings program such as a 529 plan for your children, especially if you live in a state with an income tax. These programs shelter the money from state and local income taxes.
Once these priorities are taken care of, the next step is a matter of preference.
You could take the money you borrowed at 3 percent and try to reinvest it in a way that earns more than that. If you have time to ride out ups and downs of the market, 3 percent should be relatively easy to beat.
Or you could pay down your mortgage quickly. If you are just going to park your money in money market funds or certificates of deposit that yield less than 3 percent, it makes sense to pay down that mortgage debt. And it sure would be nice to have no mortgage when you retire.
There are other situations where it’s smart to pay down a mortgage early.
The first scenario is when you’re trying to eliminate the cost of private mortgage insurance, or PMI. That’s the insurance you must carry if you put down less than 20 percent on your home. It makes sense to speed up payments on your principal until you’re allowed to drop the insurance.
It’s also good to pay down your mortgage if you don’t have the discipline to reinvest extra money wisely. Handing the money to your mortgage company is one way to protect you from yourself.
Even if paying down a mortgage fast is the best choice, there are smarter ways than opting for a 15-year loan. That’s because the shorter term locks you into a higher payment, and that can become a burden if money gets tight.
A 30-year loan gives you options. If find yourself with extra money, then pay down the principal as aggressively as you like. But if you’re short, scale back to the regular monthly amount. That flexibility is probably worth the slightly higher interest rate on the 30-year loan these days, Sharvin says.
To compare a 15- and 30-year mortgage, consider this example: One homeowner with a $200,000 loan chooses a 3.75 percent 30-year mortgage, which costs $926 per month. Another chooses a 3 percent, 15-year mortgage, which costs $1,381 per month.
The homeowner with the 30-year loan ends each year with $5,460 in savings from lower payments and a tax break of about $770. He puts all that money into a 401(k), saving himself an additional $1,560 in taxes. That’s a total annual savings of about $7,800. If he earns a 5 percent return over 15 years, the homeowner will have accrued $170,000.
The homeowner with the 15-year loan will have no extra savings after 15 years. But then his mortgage payments will end. He’ll try to catch up, but he’s starting from so far behind that by the time 30 years are up — and both loans are paid off — the homeowner with the 30-year loan will have $124,000 more in savings.
chatmandu002 posted at 9:03 am on Fri, Aug 31, 2012.
Pay all debts down as fast as possible. If re-elected the president is taking us over the cliff then it's already too late.
clotheshog posted at 9:13 am on Fri, Aug 31, 2012.
and if R & R get elected, there will be no mortgage deduction....
mwmike posted at 9:59 am on Fri, Aug 31, 2012.
We've been over that Bush/Republican cliff already. The American people will never make that mistake again.
Ron S posted at 8:19 pm on Fri, Aug 31, 2012.
This is a really interesting subject. Although a number of points above are certainly valid, there are a couple of caveats. I often listen to Dave Ramsey, an anti-debt guru who has a nightly radio call-in program, and this question comes up almost every night. It is true that high-interest and/or smaller debts should normally be paid off first, so that that freed-up money can then be applied to larger amounts. But, as touched on above, some people have enough cash to pay off or pay down their mortgage, but wonder if it's a better idea to invest that money in potentially risky but also potentially higher yield devices. The way to answer that question is this: If your house was paid off completely, would you go and take out a new loan against that house to invest in the stock market or some other endeavor where you might lose that money if things go south? Most will answer no to that question, but you are doing exactly that if you invest instead of paying off the loan. The other point is one of taxes. Think about how much interest you pay vs. what you get back in April. Let's say you pay the bank $10K in interest, are able to deduct it all at the end of the year. If you're in a middling tax bracket, you'll get back maybe $2500. Where did the other $7500 go? It went to put the banker's kid through college or buy them that bass boat. Wouldn't it make more sense to just pay the extra $2500 but keep the $7500 in your own pocket, to maybe put your own kid through college? Finally there is the emotional aspect, and the long-term repercussions of that reduced debt. I paid off my first house ~20 years ago. It was a feeling like no other, and by having the discipline to do that then I have not had a mortgage since, 3 houses later. It gives you a freedom that the person paying $1500/month simply does not have. If you can do it, then do it--you won't regret it. As Dave says, "Live like no one else now, so you can live like NO ONE ELSE later."
wdgnas posted at 6:22 am on Sat, Sep 1, 2012.
You could take the money you borrowed at 3 percent and try to reinvest it in a way that earns more than that. If you have time to ride out ups and downs of the market, 3 percent should be relatively easy to beat.
if the reinvestment fails your money ends up where? why money heaven of course.
show me a guaranteed 5 % over 15 years. better yet, guarantee me 5% over 15 years. not going to happen.
remo303 posted at 10:04 am on Sun, Sep 2, 2012.
Hmmm....let's think about this:
Pay off mortgage, leaving an extra $1000-1500 each month to then pay off other debts, which will then free up an additional $1000 or so to then combine with the (now extinct) mortgage payment for solid and suitable investment for retirement.
Or...
Listen to people in the banking industry tell you "what is best for you."
What was the question again?
loaning cash posted at 1:40 am on Tue, Sep 4, 2012.
Paying of mortage is the most popular quiestion now. You have to have a really well-paid job to afford it. SO maybe we should better start from basics of this question. I am not saying that reducing mortage rate isn't important. I wish it was as easy as getting cash loan online , but probably it'll only happen in future