Principal Payments on Mortgage

Options:

1) Refinance the mortgage at a lower interest rate. Make sure the savings more than cover closing costs, including any points charged for refinancing.

2) Switch mortgage term from 30 to 15 years. The monthly payment on a $100,000 15 year mortgage at 8% is $956, or $222 more than on a 30 year mortgage. However, the total interest paid on the 15-year mortgage is reduced to $72,080. That is $92,160 less interest paid on a 15-year mortgage than on a 30-year mortgage.

3) Begin paying an extra amount toward principal each month or at regular or irregular intervals.

CAUTION: Before prepaying a mortgage, consider investing the maximum possible in retirement plans--for example, 401(k), fully funding a regular or Roth IRA account, if eligible, paying off personal credit card debt, and accumulating an adequate amount of emergency funds. Consider the opportunity cost of funds used to prepay on a mortgage and plans for long-term investing, insurance needs, tax and retirement planning, etc. The funds may do better in the US stock market with historical returns of 10% or more. For a conservative investor buying bonds, money market funds and CDs, making extra mortgage payments may be a smart move.

Tax Analysis: Where to invest extra funds should be based on whether after-tax return on an investment is greater than the after-tax cost of the existing mortgage. Assume the taxpayer in the previous example will itemize deductions and has a combined federal and state marginal tax rate of 34%.

--Mortgage Interest Rate = 6.0%
--Less: Tax Deduction (6% x 34%) = 2.04%
--Taxpayer's Net After-Tax Cost = 3.96%

For every $1 paid in mortgage interest, there is 34 cents in tax savings and the taxpayer pays 66 cents. Similarly, if the taxpayer has a taxable investment that earns $1, the taxpayer keeps 66 cents. Unless an after-tax return on an investment is more that 3.96%, it is better to pay down the mortgage. Consider risk when investing compared with no risk when paying down a mortgage.


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