Traditional wisdom holds that paying off your home mortgage ahead of schedule is a good way to save money, since you’re no longer forking over big bucks in interest to the bank. While owning your home outright can give you a tremendous sense of freedom, it’s not necessarily worth it if you have to sacrifice other goals along the way.
If you’re considering speeding up your home loan payoff, it helps to look at the bigger financial picture first. There are some situations where throwing every penny at your mortgage debt could actually end up costing you money. Here are some questions to ask yourself before you pull the trigger.
1. Do you have anything set aside for rainy days?
An emergency fund is one of the most basic financial tools that everyone needs to have and it’s something that every finance expert recommends. Having 3, 6 or 9 months’ worth of expenses socked away in a bank account earning some interest can come in handy if you lose your job or end up with some big medical bills after an unexpected illness.
Building an emergency fund is especially important if you own a home since there’s no landlord to bail you out if something breaks. If you’re funneling all of your spare cash into paying down your mortgage, you could be in a tough spot if the furnace conks out or you need to get the roof replaced.
When you don’t have any savings, financing repairs with a credit card or loan may be the only solution and if you get stuck with a high interest rest, it’s bound to be an expensive one. If you’re still determined to get rid of your mortgage as quickly as possible, dividing the extra amount you’re applying to the principal and putting half into a savings account can help you get closer to your goal and minimize the financial impact if an emergency comes up.
2. What kind of return could you get?
The next thing you need to think about before you try and wipe out your mortgage is how much you stand to save in the process. If you’ve been paying on the home for awhile already, you’ve probably paid in the biggest part of the interest already. When you only have 5 or 10 years left on the mortgage, accelerating your payoff may not save you as much as you think.
For example, let’s say you have a $200,000 mortgage at a 4 percent interest rate with a monthly payment of $950. Assuming a standard 30-year loan, you’d pay about $143,000 in interest if you just make the regular payments. If you were to add an extra $100 to your payments, you’d get rid of the loan 5 years earlier and bring the total amount of interest down to roughly $116,000.
That’s a savings of about $27,000 but now consider what would happen if you put that extra $100 a month into an IRA instead. After 30 years, your home would be paid off and you’d have just over $121,000 saved for retirement, assuming a 7 percent annual return. When you look at it that way, paying the mortgage down early doesn’t necessarily seem like the wisest investment.
3. Do you have any other debts?
If you’re shelling out money every month for high interest credit card debt, making that the focus instead of your mortgage is the better option. Mortgage rates are in the 4 percent range these days but the average credit card interest rate has hovered around 15 percent for the last couple of years.
Let’s say you owe $10,000 and you’ve got a 15 percent interest rate. With a minimum payment of $300 a month, you’d pay it off in just under 4 years and hand over $3,000 in interest. Now if you tacked on an extra $200 a month, you could shave the interest and the repayment period virtually in half. Once you’ve dumped those credit cards, you can use that $500 to attack your mortgage with a vengeance.
4. Do you need the tax break?
One of the advantages of being a homeowner is that it can yield some money-saving benefits at tax time. Generally, you can deduct the interest you pay for a primary mortgage loan up to the first $1 million in principal and up to $100,000 in interest on secondary mortgage loans. You do need to itemize to claim the deduction.
So why are deductions so important? Unlike a credit, which is applied directly towards the amount of tax you owe, a deduction reduces your taxable income. If you’re also deducting things like business expenses or charitable donations, adding in your mortgage interest could push you into a lower tax bracket, which could qualify you for additional tax credits.
When you combine the value of credits and deductions, the end result is either a lower tax bill or a bigger refund. If you don’t have any mortgage interest to deduct, that can make a significant difference in what you owe once April 15th rolls around.
5. How’s your nest egg doing?
Living in a paid off home in retirement isn’t much to brag about if you don’t have enough cash to cover your other expenses. Saving early and often is the best rule to follow when it comes to planning for the future but if your retirement accounts are looking a little skimpy, it might be time to rethink your mortgage payoff plan.
Let’s say you’ve got a 401(k) through your job that you’re putting 6% of your $50,000 annual salary into. Your employer matches half of what you put in. After 30 years, you’d have about $440,000 saved, with a 7 percent annual rate of return. If you were to increase your contribution rate to 8%, which comes out to less than $100 more each month, you’d have $540,000 instead. That’s 100,000 reasons to move building your nest egg higher up on your list of priorities.
Final thoughts
Not having a mortgage hanging over your each month is certainly a great feeling but only if you’ve gotten all of your other ducks in a row. Making sure you’ve cleared your other debts, saved a little for emergencies and gotten a decent head start on retirement are all important things to consider crossing off your financial to-do list first.
