January 28th, 2016 7:43 AM by Jackie A. Graves, President
probably dreamed of the day when you finally send in your last mortgage check
and own your home free and clear.
Paying a little extra every month on your home loan is a way to
make that dream a reality faster than you thought, and with today's
historically low savings rates, it could make more sense than ever.
Rather than letting money languish in a CD, money market or
savings account that pays practically nothing, many homeowners might be better
served by paying down their mortgage.
Doing so can save tens of
thousands of dollars in interest and shave years off your loan. Our accelerated
mortgage payoff calculator can
help you figure out how quickly you can pay off your loan and how much you'll
"It can be life-changing," says Jonathan Pond, a
financial author and adviser from Newton, Massachusetts, who believes paying
off your mortgage early can be one of the smartest moves you can make,
especially as you reach retirement.
But before you start sending your spare cash to your mortgage
company, you need to make sure your overall finances are in order. Paying extra
on your home loan isn't always the smartest use of your money.
"We look at the whole picture when trying to make that
decision," says Diane Pearson, a certified financial planner and
shareholder at Legend Financial Advisors in Pittsburgh.
Example: 30-year loan, 4.0% rate
Time shaved off loan
Interest payment saved
4 years, 11 months
8 years, 5 months
Here are three things you must do
before paying extra on your loan:
Pay off high-interest credit card debt: With the average variable credit card
interest rate at 15.76%, you'll save a lot more by paying down your card
balances than by paying extra on a home loan that carries a 4% or 5% interest
Plus, you can usually deduct mortgage interest from your taxable
income. Credit card interest isn't tax-deductible.
Build up your emergency savings: Everyone needs about six months of living
expenses in a savings or money market account, where you can withdraw it
quickly and without penalty.
Without that financial cushion, you could lose your home,
including the extra money you worked so hard to put toward the balance, if you
get laid off or become ill and can't work.
Contribute to your retirement plan: If your employer matches all or part of your
contributions to a 401(k) plan, make sure you're putting in enough to collect
the full benefit.
Not taking advantage of matching retirement fund contributions
is saying "no thanks" to free money.
If, for example, your employer matches 50% of your contribution
up to 6% of your income, that's like getting a 3% pay raise and earning a 50%
return on your investment.
Finally, you should consider whether the potential gains from
investing the money in long-term options such as stocks could be greater than
what you'll save by paying down your home loan.
Over the past 40 years, the S&P 500 — a broad measure of
stock market performance — has delivered an annualized return of 11%.
But late summer's wild gyrations have reminded us that you must
be willing to stick with the market long enough for the inevitable ups and
downs to deliver those profits.
If that's not for you, or if you already have enough money in
stocks and the rest of your finances are in good shape, then this is the time
to consider paying down your mortgage.
That's especially true if you've been putting money into more
conservative options such as CDs, savings or money market accounts that pay
less than 2%.
Economists Gene Amromin of the Federal Reserve Bank of Chicago, and Jennifer
Huang and Clemens Sialm of the University of Texas at Austin, recommend a
simple way to decide if that's true:
Multiply your mortgage interest rate by 1 minus your tax rate.
If the result is higher than what you typically earn with a conservative
investment, pay down your home loan. Otherwise, the savings option is better.
your interest rate is 4% and your tax rate is 25%: 1 minus 0.25 equals 0.75.
Multiply 0.75 times 4% and the result is 3%. That's the real interest rate
you’re paying after taking into account the mortgage tax deduction.
If you're getting a rate of return higher than that, then you
should leave your money where it is. If not, then putting the money into paying
down that loan could be your best bet.
Some people think they should avoid paying off their home loan
early to keep reaping the tax benefits that come with the mortgage deduction.
But Pond says, "The notion that you need a big mortgage to
save taxes is absolute nonsense."
If you're in the 25% tax bracket and you pay $10,000 a year in
principal, he notes, you reap a tax savings of $2,500: "So you're paying
$10,000 to save $2,500."
You don't have to pay lots of fees to pay off your loan more
Our 3 free ways to pay extra will show you how.
Whatever method you choose, paying off the mortgage could well
reduce the amount of income you need in retirement by 20% or more, Pond says.
"Almost inevitably with a mortgage, there are going to be
financial challenges," he says about the clients he's advised, "while
those that retire without a mortgage pretty much have clear sailing ahead.
"It's that stark."
Reed Karaim – To view the original article click here