How Should You Pay Down Your Mortgage?
Once you sign the paperwork and move into your new home - if you did not pay cash - you will soon have to make that first mortgage payment.
Once you have that mortgage statement in your hand, you might ask, should I make the minimum suggested payment? Or should I try and pay down the mortgage faster?
This guide shows you how to approach paying off your mortgage, including ways to pay down the principal faster and the reasons you may want to prioritize paying other debts first. Before making any decisions, you may want to speak with a financial consultant to discover the options you have and see what decision may fit your specific situation.
Do Mortgage Interest Rates Affect Payment Options?
The interest rate homeowners pay for a mortgage, compared to other debts, may effect the outcome of any financial decisions. Current mortgage interest rates are hovering close to historic lows. Even with a mortgage interest rate a percentage point or two higher, the interest rate you might be paying on a mortgage is usually far lower than a credit card or a personal loan.
Low mortgage interest rates are a relatively recent trend. Twenty years ago, new home buyers paid 8 percent on average for their mortgages. And in the early 1980s, people that took out mortgages, had interest rates as high as 18%! In this case, the difference between an 18% mortgage interest rate and lower percentage credit card, was probably much greater that it would be today. However, today, the situation might be reversed, with a much lower mortgage rate and a much higher credit card percentage rate.
When looking at the interest rates on your debt, including your mortgage, note that interest is typically compounded similarly on most loans over one year. The interest cost on an annual percentage rate (APR) of 18% on $100 of debt is almost always going to be more than an APR of 4-5% on $100. As a result, many financial experts recommend starting to pay off debts with the highest interest rates first.
Existing Debt vs Equity
The build-up of equity in a home, without paying any additional mortgage payments, may affect your decision of what debt to pay-off first. Your home is often one of the things that you own that actually appreciates in value over time. In most cases, long-term home-ownership does organically increase equity in the property - without aking any additional payments to principal (other than those mandated by your monthly house payments.) However, in some cases, a homeowner cannot rely on owning the home over a 10-year or 20-year period waiting for an improvement in home value. Consider the following scenarios:
- The need to sell the home in just a few years, due to a change in circumstances
- Purchasing the home with a low down payment, thus starting with little equity in the property
- Buying a home in an area with slow growth, or even possibly having a decrease in home value vs. an increase.
These are all situations in which you might decide to pay off a portion of the mortgage as quickly as you can. With a careful plan, you can balance your needs to pay off other debts while you improve your equity.
How Do You Pay Off A Mortgage Faster?
There are several ways to pay down a mortgage faster than the given monthly house payment. The first is simple: pay more principal on each monthly mortgage payment. The added benefit to this approach is that you do not have to negotiate anything special with your lender.
Paying an extra $10-$15 a month in principal is not likely to make a huge difference in your total interest paid, unless you can consistently do it every month. Increasing the principal amount, however, does improves the interest savings. Paying an extra $100 a month, every month, on a $100,000 mortgage could shave over eight years off the mortgage and save $26,000 in interest.
Many homeowners are fans of the biweekly mortgage plan, but many financial experts have mixed feelings on the practice. In theory, asking your lender or mortgage servicer to structure your mortgage payments on a biweekly plan allows you to make 26 half-payments per year, which translates into one extra monthly mortgage payment each year.
Some people expect the mortgage servicer to apply each half-payment immediately (therefore reducing the principal faster), but most typically just apply the payments once a month. The real benefit comes in that extra month of payment each year.
Should A Homeowner Use Bonuses and Cash Windfalls to Pay Off A Mortgage Early?
Your mortgage will likely be a part of your life for many years. Avoid any regrets by understanding how they function, and how to pay them over time!
At certain times in your life, you may receive a lump sum of money and have to figure out what to do with it. Putting it toward your mortgage may make sense, but there are probably alternatives as well.
First, either speak to a financial planner or see what you might gain from investments before you pay off any lump sum debt. For example, if you have a mortgage interest rate of 4.5%, it might make more economic sense to invest the money for a possibly higher investment yield.
Do Tax Benefits Make a Difference?
The mortgage interest tax deduction could possibly create some additional savings for you that justifies the existence of the mortgage, especially in the early years of the loan. For most mortgages, you can deduct the interest you pay. However, the Internal Revenue Service (IRS) requires you to itemize deductions in order to claim the deduction.
Itemized deductions typically must exceed the current standard deduction. The amount of savings through the home interest deduction depends on your tax rate. The longer a mortgage is paid, less and less of the amount goes to interest expense, while the remainder goes to principal. In many cases, on an older mortgage, the mortgage interest amount might be less than the standard deduction - thus making the deduction worthless.
Could Mortgage Refinancing Be a Better Choice?
In some cases, people find themselves with a mortgage loan that does not really work well for their needs. While paying off the mortgage earlier is certainly an option, it may not be as wise as refinancing the mortgage. Refinancing a loan should always be compared with all the facts available, since it may not uniformly generate much on monthly or yearly savings. People may decide to refinance to save money under these conditions:
- To receive a lower interest rate
- To reset the loan to a higher value, eliminating private mortgage insurance
- Roll high-interest debts into a new mortgage.
Even if one of these scenarios may apply, you should aim to balance future savings with current costs. You can expect to pay at least a few thousand dollars in closing costs, so you should gain additional benefits on top of any immediate expenses.
Paying off your mortgage early is a highly personal decision. It depends on any other debts, personal investment plans, the current mortgage loan and tany tax benefits you may receive. It is always best to inform yourself before making decisions, as a smart decision with your mortgage could end up saving you a lot of money in the future!
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