Should I Pay Down My Mortgage?

Mortgage rates, currently at historic lows, about 5 percent, are so low that homeowners should consider whether to make extra mortgage payments to pay off their debt early. Would it be more fiscally prudent to invest those extra mortgage payments someplace with a higher return? Perhaps keeping extra cash someplace more liquid than a mortgage might be a safer approach given these economically trying times? Before answering these questions, one must first contemplate the following: How likely are you to leave the extra money in savings and how good would it feel to wipe your debt out years earlier than your mortgage requires.

First: If you have high interest rate credit cards, pay them down first. Don’t even think about making extra mortgage payments until the credit cards are paid in full.

Second: If your employer has a matching 401(k) or similar account, put your extra savings there first until you have maxed out your employer’s contribution.

Third: make sure you have an “emergency” fund set aside before making extra mortgage payments.

What is your real interest rate?
The interest rate that you are paying on your mortgage (5%) is not your real rate because you will receive some of the interest back each year in the form of a tax deduction. For example, if you have a household income of $175,000.00 and are paying 35 percent of that in total to the state and federal government in taxes and you pay $20,000.00 in mortgage interest each year, the deduction effectively brings your taxtable income down to $155,000.00. As a result, you are paying $7,500.00 (35% of $20,000.00) less in taxes than you would have without the deduction. Therefore you are not paying $20,000.00 in mortgage interest but rather $12,50000 after you subtract the $7,500.00 in savings. Your after-tax interest rate on your loan is more accurately 3.25% (35% of the 5% interest rate that you are paying).

Can you get better returns?
In order to take advantage of the benefits of such a low interest rate on your home mortgage, you must find investments with a return greater than 3.25%. You must also guard against taxes chipping away at the money you are saving instead of making extra mortgage payments. Roth IRSa, 529 college savings accounts, health savings accounts and tax free municipal bonds all shield the investments from taxes.

The emotion factor.
Despite the benefits of taking the money you would use to make extra mortgage payments, the need to pay down the debt, for some, is more important than the economic benefits. Sleeping at night must come first and it is rare that a person who pays down a mortgage early has second thoughts about the gains that might have been realized had the money been invested elsewhere. Make sure, however, that if you choose to pay down the mortgage, extra payments are credited to principal. You will not lower your monthly payments but you will reduce your principal balance and the term of your loan will be shortened significantly depending upon the amount you prepay.

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