The impulse to pay off your mortgage more quickly than you need to is understandable, especially these days.
Interest rates are near historic lows, so it’s possible to replace a 30-year mortgage with a 15-year loan and still afford the monthly payments. Or, if you’ve already refinanced at a dirt cheap rate, you can take those savings and pay down your principal faster.
But the allure is more emotional than financial. Mortgage debt provides great financial flexibility, and paying it down fast probably isn’t the best way to grow your nest egg.
“Generally speaking, there’s no advantage to paying down a mortgage earlier than you need to,” says Greg McBride, senior financial analyst at Bankrate.com
That’s because the interest on mortgages is low, it helps lower your taxes, and paying less every month gives you chance to reinvest the savings in more productive ways. Among the better options: paying down higher-interest credit cards, or saving for retirement.
Start with rates on 30-year mortgages. The average rate is 3.66 percent, close to the lowest level since the 1950s.
But in reality you pay an even lower rate when factoring in tax breaks. The federal government gives borrowers a break by allowing them to deduct mortgage interest from their income. And if instead of using the extra cash to pay down your mortgage you put it in a tax-advantaged retirement fund like a 401(k), your taxes are reduced even further.
Jim Sharvin, a certified public accountant with the firm McDowell Dillon & Hunter in Torrance, Calif. says if you are thinking of paying down the principal of a mortgage more quickly than necessary — either by switching to a shorter-term loan or sending extra principal payments to the bank — consider first doing the following:
— Pay down all high-interest debt, like a credit card. It’s the first priority because it’s very expensive debt, and it has no tax or other financial benefit.
— Build a cash cushion to cover unexpected expenses or loss of income.
— Bolster your retirement savings by putting the maximum amount allowed by law into a tax-sheltered plan such as a 401(k), a 403(b), or IRA. This also reduces your taxes.
— Fund a college savings program such as a 529 plan for your children, especially if you live in a state with an income tax. These programs shelter the money from state and local income taxes.
Once these priorities are taken care of, the next step is a matter of preference.
You could take the money you borrowed at 3 percent and try to reinvest it in a way that earns more than that. If you have time to ride out ups and downs of the market, 3 percent should be relatively easy to beat.
Or you could pay down your mortgage quickly. If you are just going to park your money in money market funds or certificates of deposit that yield less than 3 percent, it makes sense to pay down that mortgage debt. And it sure would be nice to have no mortgage when you retire.
There are other situations where it’s smart to pay down a mortgage early.
The first scenario is when you’re trying to eliminate the cost of private mortgage insurance, or PMI. That’s the insurance you must carry if you put down less than 20 percent on your home. It makes sense to speed up payments on your principal until you’re allowed to drop the insurance.
It’s also good to pay down your mortgage if you don’t have the discipline to reinvest extra money wisely. Handing the money to your mortgage company is one way to protect you from yourself.
Even if paying down a mortgage fast is the best choice, there are smarter ways than opting for a 15-year loan. That’s because the shorter term locks you into a higher payment, and that can become a burden if money gets tight.
A 30-year loan gives you options. If find yourself with extra money, then pay down the principal as aggressively as you like. But if you’re short, scale back to the regular monthly amount. That flexibility is probably worth the slightly higher interest rate on the 30-year loan these days, Sharvin says.
To compare a 15- and 30-year mortgage, consider this example: One homeowner with a $200,000 loan chooses a 3.75 percent 30-year mortgage, which costs $926 per month. Another chooses a 3 percent, 15-year mortgage, which costs $1,381 per month.
The homeowner with the 30-year loan ends each year with $5,460 in savings from lower payments and a tax break of about $770. He puts all that money into a 401(k), saving himself an additional $1,560 in taxes. That’s a total annual savings of about $7,800. If he earns a 5 percent return over 15 years, the homeowner will have accrued $170,000.
The homeowner with the 15-year loan will have no extra savings after 15 years. But then his mortgage payments will end. He’ll try to catch up, but he’s starting from so far behind that by the time 30 years are up — and both loans are paid off — the homeowner with the 30-year loan will have $124,000 more in savings.
Follow Jonathan Fahey at http://twitter.com/JonathanFahey .