In today’s economy, the attraction of quickly reducing and possibly eliminating the burden of a mortgage is very appealing to many home owners. But, is paying down your mortgage really the best idea?
The average consumer may argue that paying off their mortgage debt faster is a smart decision since ridding oneself of quite possibly the largest financial obligation they will ever see will put more money in their pocket every month. To an extent, this is true. However, in a market where interest rates are at historic lows, the decision to pay down a mortgage could hinder, rather than promote your financial growth.
Mortgage rates have dipped under 3.50% and it is possible to refinance to take advantage of the potential savings and pay down the principal balance even faster. It is even possible to replace a 30 year mortgage with a 15 year mortgage and have affordable monthly payments.
According to senior financial analyst at Bankrate.com, Greg McBride, “Generally speaking, there’s no advantage to paying down a mortgage earlier than you need to.” The reason for this is because the mortgage interest rates are extremely low, the mortgage helps lower your taxes, and, perhaps most importantly, paying less each month will allow for reinvestment. The excess money that you save could be put towards better use, such as credit card debt, saving for college, saving for retirement, or general saving for growing your nest egg.
With the mortgage rates at historic lows, the benefits are two fold: less interest on your mortgage and you pay a lower rate when factoring in tax breaks. According to an article in Florida Realtors News, “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.”
For those who are considering paying down a mortgage faster than necessary, there are some things to consider, according to Jim Sharvin, a certified public accountant with the firm McDowell Dillon & Hunter in Torrance, Calif:
- 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. *Florida does not have a state income tax.
What you do next is up to you.
The most logical choice would be to reinvest your money at a rate that exceeds the mortgage interest rate that you could be paying. For example, assume you could refinance a mortgage to 3.50%. You could take your money and reinvest so that you earn more than 3.50% return. In a general sense, this would be easy to beat, despite the crests and troughs of the market.
If you do not want to have that mortgage hanging over your head when you retire, paying down your mortgage is an option if you do not plan to put your money in a security that will yield a higher return than the rate of interest on your mortgage.
However, there are scenarios where paying down your mortgage is a good idea.
For one, you can eliminate the private mortgage insurance (PMI). PMI is required by borrowers who put less than 20% down on their home. Perhaps increasing the payments until you can eliminate PMI is a good idea.
The other scenario, and one that is very common, is that people lack financial discipline. If you have trouble managing your investments and do not have the discipline to reinvest your money properly, this could be difficult for you.
There are smarter ways to produce financial success than opting for a 15 year mortgage. According to Sharvin, “A 30-year loan gives you options. If you 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.”
To fully illustrate this, I pulled an example in an article by Florida Realtors:
“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.”
The decision to pay down a mortgage is up to the consumer. While the prideful allure to reduce your debt is tempting, there are smarter ways to nurture financial success. Maximizing your financial assets is imperative for both short-term and long-term stability. What’s good for me is not necessarily good for you. Specific to mortgages, one of the best pieces of advice that can be given to consumers is just because you’re approved for the loan, doesn’t mean you can afford the loan. Take your time, do your due diligence, and make the best and most responsible decision for you when purchasing, selling, or refinancing a home.
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