Interest rates are so low these days that you may think it’s impossible to find a no-risk investment that pays 5 percent or more. Yet that’s what you’ll earn if you make extra payments against your mortgage. Paying off your mortgage early saves a lot of interest because the total amount of money you fork over to your lender will be less — sometimes far less — than it would be if you took the typical 30 years.
There’s an added advantage for anyone planning for retirement: If you pay off your mortgage by the time you retire, or shortly thereafter, you'll require less income to support yourself during retirement. Retirees who are still making mortgage payments or are renting need to come up with a big chunk of change every month.
Pros and cons of mortgage prepayment. The classic argument against making extra mortgage payments is that you can earn a higher return from the stock market than you can from the interest you save on your mortgage. That's not always the case. In the past decade, the Standard & Poor’s 500 Index, the benchmark for stock returns, has lost money.
Even if you believe that stocks will do better over time, if your investments are diversified, some of your money is held in interest-earning investments. Money-market funds, CDs and savings accounts are paying miniscule interest. In a low interest-rate environment, it can make more sense to use that money to reduce your mortgage balance instead.
Other opponents of prepaying a mortgage argue that you’ll be giving up a lot of the tax savings on the mortgage interest. True, every extra payment reduces the deductible interest on the loan. But even though your tax deductions shrink when you accelerate mortgage payments, you're usually still ahead financially because for every dollar of mortgage interest you pay out, you save only a fraction of that dollar in taxes.
Besides, the portion of your monthly payment that goes to interest gradually subsides over the life of the loan. Toward the end of your mortgage, virtually all of your payment goes to the principal, which isn't tax deductible.
Some priorities trump prepayment. There are legitimate reasons why you should delay making extra mortgage payments. Before you write a big check to your home lender, be sure these financial priorities are addressed:
- You need an emergency savings fund equal to at least six mortgage payments in case you run into a financial bind.
- If you’re still working, you need to contribute generously to available retirement plans, including your retirement savings plans at work and an individual retirement account. While there are lots of financial benefits to reducing your mortgage, tax-advantaged retirement savings plans offer better ones.
- You should pay off all other higher interest loans, including credit card loans and car loans. It makes no sense to make extra payments against your, say, 6 percent mortgage while you've got an 11 percent car loan and a 19 percent credit card balance.
The extra-mortgage-payment payoff. There are several ways to go about paying off a mortgage early, including refinancing to a 15-year mortgage, making an extra payment every year or paying more every month. The best one for you depends in large part on how much cash you have to spare. No matter which strategy you choose, keep in mind that a little extra goes a long way.
Consider this example: A couple in their 50s have 20 years left on a $250,000, 30-year mortgage. The interest rate is 5.5 percent, resulting in a monthly principal and interest payment of $1,420. By paying an extra $200 a month, the mortgage would be paid in full in 16 instead of 20 years. An extra $400 a month would speed up the payoff time to 13.5 years; an extra $600 a month, 11.5 years.