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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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2011-12-09, 16:59:40
anonymous from United States  
Pay as much towards the principal as you can, whatever the 'magic' number is.
More you pay, faster you get out.
Can you imagine how good it feels being completely debt free?
Maybe that's just me but I don't see myself making mortgage payments after retirement. This is stupid!!! There is no guaranty you'll be able to make payments after the retirement.
Pay now, pay as much as you can, pay every month and you'll be on the top!
2012-01-23, 03:15:39
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2012-02-22, 11:01:46   (updated: 2012-02-22, 11:02:44)
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2012-02-26, 07:27:20
johnballsr@yahoo.com from United States  
I owe $160,000 on a $220,000 mortgage at 6.9%. I want to know if I can put a $30,000 lump sum on my principal before I refi to get my balance down to $130,000? Thank You
2012-04-18, 12:13:54
ohiodale1 from United States  
A big advantage of paying off a mortgage is you get rid of the monthly house payment. Say you borrow $100K at 4.5% fixed interest. You would average $2250 per year in interest payments over the term of the loan. If you were in the 25% tax bracket you would really only pay an average of $1,688 per year. This equates to $140 per month. A typical house payment on a 15 year loan at 4.5% is about $750 per month. I would much rather have an extra $750 per month to spend than pay it in a house payment. As far as the tax savings is concerned. You really are not saving money you are just getting a little of your money back. Once you pay off the house invest the $2250 in an IRA and you would get the exact same tax savings. The only real argument for not paying off ones house is when inflation is higher than the effective interest rate. With the current US borrowing, the current printing of trillions of dollars, and the overall federal spending we could easily see double digit inflation but until that time I would suggest paying off the house as quickly as possible. Just think, once the house is paid for and we have double digit inflation your house will go way up in value. Of course the dollar will be worthless so it will not matter.
2012-06-15, 19:26:05
anonymous  
god bless you liars
2012-09-03, 11:27:41
anonymous  
will it be to my advantage to refinance a 20-year mortgage loan at 5.5% signed in 2004, remaining 12 years to a 10-year fixed.. Monthly mortgage payment will be the same under new refinance rate, but it would save 2 years. I am in 15% tax rate. Does it make sense to refinance?


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2012-10-29, 11:55:55
tkaye from United States  


My question is this; I owe 41,000 on a property that is in bad shape. I have a couple wanting to do a lease to own. They have 10,000 to apply to the agreement. How much of this should I apply to the principal and how much towards future payments?

Thank you
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2015-02-27, 09:55:15
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If I pay 75% off of my mortgage will my monthly payment decrease by 75%?
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