Each year, about one in six Americans makes extra payments on their mortgage in an effort to own their home sooner. But is paying off your mortgage always a good idea?
How can paying off debt be a mistake? That’s a fair question, especially when you look at how much interest you can save through prepayments. Say you have a $200,000 mortgage at a 6 percent interest rate for 30 years and you make an extra payment of $2,000 annually. You would pay your loan off seven years faster and save more than $68,400 in interest. Those are pretty impressive numbers!
However, consider the following:
1. Mortgage interest
If you deduct mortgage interest on your tax return, your savings from paying down your mortgage might actually be considerably less. If you are taxed at 20 percent, you’re effectively paying just 4.8 percent interest on that 6 percent interest rate mortgage. Your total interest savings from paying off your mortgage early in the above example, would therefore be less than $50,000.
2. Retirement savings
You may be able to save more in the long run if you direct that extra money into a tax-deferred retirement savings plan. More than a third of American households currently do not take advantage of retirement plans sponsored by their employers, in some cases because they’re putting too much into their mortgages. If your employer matches 50 percent of your contribution, as many do, not taking full advantage of such a plan is giving up a lot of free money. For example, say you earn $35,000 and are taxed at 20 percent:
If you put $175 per month into your 401(k) account
(Instead of making an annual $2,000 mortgage prepayment)
You’d save $35 a month in tax
Plus, earn an extra $87.50 a month (if your employer adds 50 percent)
If your investments grow at 6 percent annually, in 22 years and three months (the time it would take to pay off your accelerated mortgage):
Your plan would be worth about $145,000.
3. Other debt
Even if you don’t have a 401(k) that’s topped up by your employer, or if you do have one and are already taking full advantage of it, you may still be able to save more by redirecting those extra mortgage payments. Remember, your mortgage is likely the lowest-interest-rate loan you have. If you’re carrying a balance on your credit card, you could easily be paying rates that are triple that of your home loan. Putting that extra cash toward your plastic debt will save you more than paying off your mortgage.
4. Insurance coverage
You may also be better off using that extra money to buy better health insurance or disability coverage, since medical bills and loss of income due to accident or illness are a factor in most personal bankruptcies and mortgage defaults. If you have children, saving for their education with a 529 college savings plan is also worth considering.
5. Peace of mind
If prepaying your mortgage is often not the best financial decision, why do so many Americans do it? Probably because there’s something deeply satisfying about owning a home free and clear. And that’s a benefit that can’t be ignored. If you’d be happier, and believe your life would be less stressful if you paid down your mortgage, then it could be the right choice for you. Achieving peace of mind can be worth the extra couple of hundred dollars a year you may be able to save by redirecting those mortgage prepayments.
Just make sure you understand the difference between bad debt and good debt. The former, such as credit card debt carries a high interest rate and does nothing to help build up your net worth. Good debt, on the other hand, carries a reasonable rate and is used to purchase something that is likely to go up in value, such as your home. In most cases, your mortgage is good debt, and you may just end up further ahead if you’re not in such a hurry to pay it off.
Check with your accountant or financial advisor to see which course of action makes the most sense for your particular situation.