For many homeowners, the monthly mortgage payment is a sizable chunk of monthly bills. You may have thought about the benefits to paying off your mortgage early. Who hasn’t? To be sure, making extra payments on your mortgage will save you thousands of dollars. For example, making just one extra payment a year on a $200,000 mortgage could save you more than $65,000.
That’s not small change – after all, what better investment is there than your home? But the fact is that most of us don’t stay in our homes long enough to pay off a 30-year mortgage. And, with interest rates still at historically low levels, the benefits of paying off your mortgage early aren’t as good as they used to be. Even if you have the means to pay off your mortgage early, many financial planners believe there are better ways to invest your extra cash.
But how do you decide what’s best? First, make sure you don’t need to use the money anywhere else. Experts advise paying off any high-interest (and non-deductible) credit card debt and any other higher-interest loans first.
Second, consider where you are with your retirement. Before you put extra money toward your mortgage, make sure you’ve taken full advantage of tax-advantaged retirement savings plans, such as your 401(k) and individual retirement account (IRA).
What about insurance? If you have dependents, you need life insurance. Make sure your policy provides enough money to cover your mortgage, living expenses and education costs. Disability insurance, while generally more expensive, is also a good idea. Your family will be protected if you can’t work.
How’s your emergency fund? Most financial advisers will tell you it’s wise to have enough in savings to cover your expenses for six months to a year.
Who should pay off early?
After you make sure your financial house is in order, it’s time to consider whether you should pay off the house you live in. Paying off a mortgage early benefits some homeowners more than others, including:
– Homeowners who don’t deduct mortgage interest. Without the tax break, the actual cost of your mortgage is higher. Paying it off early makes sense.
– Homeowners who pay PMI. Lenders charge PMI to borrowers with less than 20 percent equity in their homes. If you’re close to 20 percent, making extra payments could put you over the top. Eliminating PMI will reduce your monthly payments, so you’ll get an immediate return on your investment.
If you’ve decided to do it, simply make an extra mortgage payment at the end of the year – and make sure you specify that the extra payment should be applied to the principal on your mortgage.
But before you do, make sure your mortgage agreement doesn’t have penalties for early payment. Most conventional mortgages don’t, but others – such as adjustable-rate mortgages (ARMs) – do.
What if I have an ARM?
What if you have an adjustable-rate mortgage? Will that affect your desire to pay down a mortgage loan? It will – and quite significantly. In fact, adding a fixed amount to your payment every month won’t reduce the term by more than a few months.
Here’s why: Every time the interest rate changes on an ARM, the mortgage payment is recalculated so that the loan will pay off in the period remaining of the original term. This means that your extra principal payments will reduce the monthly payment at the rate adjustment, relative to what it would have been if you had not made those payments.
It’s an important difference between fixed-rate and adjustable-rate mortgages that borrowers need to consider very carefully when deciding what to do. When borrowers make fixed extra payments to principal on a fixed-rate mortgage, they shorten the term but don’t affect the payment. When they make fixed extra payments to principal on an ARM, they reduce the payment on rate adjustment dates, but don’t change the term.
The only way to shorten the term of an ARM mortgage using partial prepayments is to increase the extra payment at every rate adjustment date.
For fixed-rate homeowners who still want to pay off their home early, consider refinancing. If you have enough money to make the larger payments – and if your current interest rate will save you at least two percentage points if you refinance (a common rule of thumb) – see if you can lower your rate further by going to a 15-year mortgage. It’s just another way to pay your home off early while still getting the deduction on your taxes.
As you can see, paying down your mortgage isn’t always the right answer. Talk to your financial planner, or ask your REALTOR® for recommendations. It’s good to get their expert advice. Ultimately, you will decide which option makes sense for you. If you need help finding a REALTOR® be sure to visit BCSRealtor.com
Patty Spiller, REALTOR®
2016 Association of REALTORS® President