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Should I pay off my mortgage faster by adding extra principal?

 

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Question:

I have been paying my mortgage for 5 years and now some extra income. Should I make additional principal payments? My mortgage is a 30-year fixed at 6.25% interest.

And how does the taxation play a role here? I am in the 25% tax bracket.


Answer:

If you prepay your mortgage or increase the monthly payment to pay of quicker, then your savings are 6.25% annually. What would you do with the money if you would NOT use it to pay down the mortgage?

You could put it in CD accounts which will yield maybe 4 to 5% interest. The benefit is that you are more flexible in case of an emergency (loss of job, health related bills).

There is zero risk in paying down the mortgage, and also zero risk in buying CD accounts, but the return of the mortgage is higher than the CD accounts.

If you buy stock, your risk is substantially higher. It is basically gambling. Your possible return is higher as well.
Investing in mutual funds on average yields 9% in the long term. However, in the short term, you may take losses. The risk is substantially lower than buying stock though.

The right decision also has to do with your age and your life, its schedule and what you expect to do in the future.

Taxation plays almost no role in the decision of whether to pay off early or invest otherwise.

Let's say you pay additional principal. That means you save interest in future payments. The interest is tax-deductible. So one could argue that the real cost of the loan is not 6.25% but 6.25% * 0.75 (since you are in the 25% tax bracket) = 4.7%

However, if your mutual fund yields 9% profit, you also pay 25% tax on that. So the effective profit is only 9% * 0.75 = 6.75%
Similarly a CD account yielding 4% effectively only returns 3% (4% * 0.75 = 3%)

The only exception is if your investment is pretax as a 401k plan or a tax-exempted bond. In that case you should compare the bond's full return against the prorated mortgage interest.

In your specific case - 6.25% is a pretty low rate. If you wait a little longer, you may find zero-risk investments such as savings accounts that will beat that return.


And now a completely different perspective on this topic:

If your mortgage is fully paid off, and your house gets hit by a hurricane or earthquake, then you are in more trouble than your neighbor who had only 10% equity in his place. You just lost all your house and try now to get money from the insurance. If the bank has the equity (and you have the mortgage) then the bank will deal with the insurance.

And there is also the thought that free and clear owners may more likely be subject to lawsuits if something happens to someone on your property. Not sure how relevant this is but I thought I should add it.


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Comments:

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2009-01-19, 21:27:50
anonymous from United States  
principal not principle
2009-02-06, 12:07:23
anonymous from United States  
My husband and I have a 30 year, 7.50% fixed mortgage. 17 years left to pay. We pay 1495.00 per month. How much extra should we pay on principal each month and how long should we pay the extra principal to shorten our years of pay back on our mortgage loan?

2009-02-08, 15:45:58
anonymous from United States  
I am planning on moving & of caorse i don't know the day nor the hour. Was wondering if i should start paying extre principle payments again. Can this help me at closing by putting extra bucks in my pocket are is this an exercise in futility?
2009-02-08, 16:06:29
Peter (Admin) from San Francisco, United States  
*Right now* I would not make additional payments. You probably do not know what your future holds. Maybe you will not sell so quickly. Extra payments made do save you interest- that is true. But you cannot get this equity unless you refinance or sell.

I write *right now* because of threats of unemployment etc etc

-Peter
2009-02-13, 09:29:23
anonymous from United States  
agains all the advise I received on blogs, I paid mine off two years ago.... HUGE piece of mind! especially in times like these
2009-02-28, 08:48:21   (updated: 2009-02-28, 08:49:44)
[hidden] from United States  
rating
I currently have some funds sitting in an account that is earning very little interest. I need to move the funds in order to try to maximize any potential interest. Can you direct me to a place in your site with information regarding this? Thank you.
2009-02-28, 08:55:36
[hidden] from United States  
rating
I currently have some funds sitting in an account that is earning very little interest. I need to move the funds in order to try to maximize any potential interest. Can you direct me to a place in your site with information regarding this? Thank you.
2009-03-01, 21:07:58
anonymous from United States  
There is a lot of misinformation in this thread.

1. Paying extra towards principal means that you have paid less interest, regardless of when you have sold the house. 2yrs, 5yrs, 10yrs.
2. Paying extra towards the principal means that you have accumulated more principal on your standard monthly payments because you have accelerated the amortization. Remember each fixed payment is part principal, part interest, and the more of the principal is paid off, the larger the percentage of your monthly fixed payment goes to principal (because you have paid less interest).
3. If you can refi or purchase a lower term loan with a lower interest rate than what you have, the savings will be even greater.
2009-03-09, 13:58:20
anonymous from United States  
Paying a extra principal payment on a loan strikes me as a scam. Why would one not invest the extra payment per month, say you get a 3%-7% return on this investment, then when the money you have saved is equal to the principal remaining in your loan pay off the principal and end the loan and any additional interest payments from that point forward.

Some people are in this situation, they could pay off the remaining principal in their loan, but instead choose to keep the loan and make ever more on the cash they have saved.
2009-03-11, 14:26:50
anonymous from United States  
Paying a extra principal payment on a loan strikes me as a scam. Why would one not invest the extra payment per month, say you get a 3%-7% return on this investment, then when the money you have saved is equal to the principal remaining in your loan pay off the principal and end the loan and any additional interest payments from that point forward.

Some people are in this situation, they could pay off the remaining principal in their loan, but instead choose to keep the loan and make ever more on the cash they have saved.


A scam? Hardly. Paying extra principal is saving you real money - you will pay less interest over the remaining life of the loan (and this applies regardless if you sell early or hold the loan to maturity), and that interest is money that is wasted. Gone. Paid to the bank.

Your scenario of investing the funds and earning 3-7% - show me where you can do that risk free. If you would have tried this stunt over the last couple years investing in stocks, where would your savings be right now? The reason prepaying the mortgage makes sense is RISK - you are getting a risk-free return equal to your mortgage rate. Every dollar of principal you pay is a dollar more of your house you actually own!

Also, taxes - investment returns are taxed at capital gains rates - so your 3-7% return (which you are taking on extra risk to try and achieve) works out to a actual gain of less than that, depending on your taxes.

Now - if you could earn more % investing risk free or low risk (money market, CDs, treasuries, etc...) than you pay on the mortgage, what you mentioned could be a viable option. But prepaying your mortgage principal is certainly not a scam - it is a complex financial decision that should be made with much research and analysis, not by asking a bunch of anonymous people on the internet.

Remember - you are going to pay back all the principal one way or another - either paying the mortgage off, refinancing (having a bank pay the mortgage off for you), selling the house (paying the mortgage off with sale proceeds), etc... so the decision rests with the interest and how that effects your finances. Calculate any interest you are making/spending - if you are investing at 1% return and paying 8% on a mortgage, it doesn't make sense to save that money - you are net down 9% (actually more due to taxes)! Putting it into the mortgage principal earns you a return of 8%, much better than 1%.

For those who want to see the result of prepaying mortgage principal, google 'mortgage calculators' or 'mortgage amortization calculators' - there exist online a wealth of tools that help you model mortgage scenarios and see how changes would impact your monthly payments and overall interest expenses.
2009-03-19, 10:06:06
anonymous from United States  
I agree with the post dated
2009-03-11, 14:26:50
. Try different scenarios using an amortization schedule calculator to see the savings in interest if extra principal payments are made. I am into 3 years of my 15 year loan. My house reappraisal showed a depreciation of $18,000. My plan to recoup this possible loss, is to start adding $300 every month to my principal payment. This saves me $10,000 in interest alone and reduces my term from 15 years to 12.5 years. I also calculated that if I sell the house before the term ended, I would not lose any money.
2009-04-22, 20:43:52
anonymous  



Keywords:
2009-04-29, 02:22:48
[hidden] from United States  
Hi,

I need help!!

I am planning to buy a house and get loan for 180k. I plan to go for 30yrs mortgage with 4.85% fixed. But then, i plan to sell it after 5 yrs.

When i sell it after 5 yrs, how mcuh have i build on my equity? As for 30yrs interest, i paid mostly 70% each month for interest only right.

What is your suggestion?
1. Go with 15yrs fixed?
2. Go with 30yrs fixed? and each month add additional $100 into principle?

2009-04-30, 21:25:11
anonymous from United States  
F*** it - Way to confusing. I'm going to rent
2009-07-14, 00:35:01
happygirl2955@yahoo.com from Bolingbrook, United States  
I recently received 50,000.00 from my deceased parents estate. I was thinking of paying down my mortgage. I presently have a 30 yr. fixed at 5%. (I refinanced 3 months ago) I want to have my mortage paid off when I retire, I am 53 and my husband is 55. We were thinking of putting down 50,000.00 onto our 164,000.00 balance and refinancing to a 15 yr loan. Should we do this? refinance or just put the money into the existing loan and pay the same payment every month until the balance is paid in full?
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