A lot people think the tax advantages of owning a home are greater than the advantages of paying off the mortgage early. But that tax advantage may not be adding as much to your bottom line as you imagine. Keeping a mortgage because of the tax advantages is a waste of money.
If you pay $5,000 a year in interest on your mortgage and are in the 25% tax bracket, the tax advantage to you is $1,250. That does not mean you get back $1,250 on your taxes, it means you can deduct $1,250 from the amount of income you earned. That means you paid $3,750 in interest to get back a portion of $1,250. The math does not make sense.
Additionally, mortgage interest is only deductible if you itemize your taxes. If you are married with children, you may get a larger tax break by taking the standard deductions rather than itemizing in order to get the mortgage interest deduction.
Eliminating the mortgage early means no more money paid in interest on that loan. You may want to begin by looking at refinancing to a shorter-term mortgage. Short term mortgages usually have interest rates a quarter to three-quarters of a percentage point lower than 30-year mortgages. But refinancing means closing costs. And a quicker payoff means higher monthly payments.
Let’s say you have a 30-year fixed-rate mortgage for $200,000 at 4.5 percent. Your monthly payment is $1,013 (Principal + Interest only.) Five years later, you refinance to a 15-year loan at 4 percent. Your new monthly payment is $1,349 (Principal + Interest only) Your monthly payment increased by $336 each month. Doing so pays off the mortgage 10 years earlier and saves you more than $60,000 in interest (if you exclude closing costs on the refi).
When considering a refinance, figure in the closing costs to be sure you are really coming out ahead financially. Also take into account how long you plan on living in your current house. If you plan on moving in less than 5 years, it’s probably better to just stick with the mortgage that you have.
If you can’t refinance, pretend to refinance by adding more money to your monthly mortgage payment. You can get all the benefits of an early payoff without the costs of refinancing by paying more in many different ways. You can also revert to paying the “normal” payment if you run into financial problems.
Each mortgage payment is made up of principal and interest. In the early years of a mortgage, most of the money you pay is interest and as the loan amount decreases, more money goes to the principal. Your goal is to pay as much in principal as possible in order to decrease the amount of the loan and get it paid off faster.
On a $200,000 30-year 4.5% example, in the first year your mortgage payments will total of about $12,000. About $3,200 is principal and $9,000 is interest payments, leaving you with a loan balance of about $196,800. If you make an extra principal payment each month in the first year (about $270/month), your loan balance would be reduced to about $193,000, saving you $9,000 in interest charges and taking a full year off your mortgage.
Another way to pay off your mortgage early is to make one extra monthly payment each year. Save 1/12 of a payment every month, and then make an extra payment every 12 months. Making one extra payment each year on a 30-year mortgage, means you’ll cut 4 years off your loan.
If your lender allows it, cut your mortgage short by making biweekly payment. Make half of your mortgage payment every two weeks. That results in 26 half-payments, which equals 13 full monthly payments each year. To calculate a bi-weekly payment, locate the principal and interest portion of your payment on your monthly statement and simply divide that number by two. Using our $200,000 30-year mortgage at 4.5%, your monthly payment would be $1,013.37 and your bi-weekly payment would be $506.69
Using ‘found’ money to pay off the mortgage works alone or with other strategies. Use any extra income that is not figured into your budget to make additional payments on your mortgage. It could be a bonus at work, a tax refund or an unexpected financial windfall. These will all help you get rid of your mortgage months or years faster.
Let’s say you have a 30-year fixed-rate mortgage for $200,000 at 4.5 percent. In year five you pay an extra $10,000 in a lump sum. Doing so pays off the mortgage in about 28 years and saves you thousands of dollars in interest payments. The downside to this approach is that it’s hard to predict the mortgage payoff date and it is so easy to funnel that extra money towards things other than your mortgage
Making an extra house payment each quarter knocks over 9 years off your mortgage and saves over $50,000! This one requires some upfront planning since making an extra mortgage payment each quarter is a large sum of money.
Before you make any changes to the amount you are paying on your mortgage, talk to your mortgage company to be sure you understand how to designate the additional payments and how they will handle them. Some lenders only accept extra payments at specific times or may charge prepayment penalties.
If you are thinking of using bi-weekly payments, some lenders will refuse to accept them because they will not accept any partial payments. It is very important to look at your mortgage documents and talk to your lender to be sure you are following the terms of your mortgage. When you make extra payments, always check the next statement to make sure your payment has been applied properly.
If you want to get serious about paying off your mortgage quickly, check out our mortgage payoff calculator (compasscatholic.org – Resources – Calculators). These calculators will help you estimate how quickly you can pay off your mortgage and become debt free.
Think of the amount that you could save if you didn’t have to pay the mortgage every month and the many other ways that mortgage money could be used. Saving for retirement or college will become much easier once that mortgage is gone. You can become more generous to causes that are close to your heart. And you may be able to save enough money to travel to the places you’ve dreamed about.
Your mortgage is probably the largest debt that you have. Which also means that you are paying the most interest on this loan. Sirach 20:11 tells us “A man may buy much for little and pay for it seven times over.”
Every time you pay extra on your mortgage, each subsequent payment reduces the total balance of your loan. Paying off a mortgage early is not easy but when you make small sacrifices to pay off your mortgage early it is a great blessing to your financial future.
Join us on the Compass Catholic podcast for more about how to pay off your mortgage.