The case for prepaying your mortgage
By Greg
McBride, CFA • Bankrate.com
We often hear the case against prepaying your mortgage
-- the low mortgage interest rate, the valuable tax deduction on mortgage
interest and the higher return possibilities in other investments.
The logic is that homeowners are better off devoting excess cash to
paying off higher interest rate obligations, debts that don't offer
the tax deductibility of interest, or pursuing higher returns in other
risk-bearing investments such as stocks.
However, there are instances where paying ahead on
the mortgage does make sense. Let's look at a few instances where
making extra principal-only payments really is a great use of extra
cash.
Many borrowers are buying homes with low -- or even
no -- down payments and paying private
mortgage insurance as a result. Until the borrower has accumulated
a 20-percent equity stake, by paying down the loan balance, appreciation
of the home and subsequent appraisal, or a combination thereof,
PMI will mean a higher monthly payment. PMI payments are not tax-deductible
like mortgage interest, so borrowers are often eager to dispatch
of it.
This is where making additional principal-only payments
can accelerate the timetable to eliminating PMI. For a $200,000
home financed with a $190,000 mortgage, it will take 9.5 years of
payments to pay down the balance enough to eliminate PMI. Relying
on the home's appreciation, and paying for an appraisal at a later
point can reduce this timetable considerably. At annual price appreciation
of 4 percent, the borrower could pay for an appraisal after 46 months
and eliminate PMI. But by tacking on an additional $60 to each payment,
this timetable is reduced to three years. Saving 10 months' worth
of PMI payments of say, $80, saves $800. Of course, eliminating
PMI is subject to a loan's seasoning requirements, so check with
your lender before ordering an appraisal. The additional $2,160
in principal payments over the first three years results in additional
equity of $2,350 at the end of year three.
Borrowers intent on avoiding PMI altogether often
take a piggyback
loan, financing 80 percent of the purchase price on a traditional
first mortgage and another 10 percent or 15 percent via a second
mortgage. Using the numbers from the previous example, a $10,000
down payment and a $160,000 first mortgage would require a $30,000
second mortgage. Making two loan payments every month gets old and
you may not want to drag out the repayment on the second lien for
10 years or more, especially if it is a variable-rate HELOC. The
sooner you can pay off the second loan, the sooner you're down to
just one monthly payment. Adding $60 per month to the 6.75 percent,
$30,000 home equity loan, knocks two years off a 10-year loan.
Low mortgage rates have been the norm in recent years,
but some people still carry mortgages with higher rates. In the
latter years of a mortgage, there may be little benefit to refinancing
into another loan and paying accompanying closing costs. At that
stage, borrowers aren't paying much interest and may not be realizing
the benefit of the tax deduction. While refinancing into a HELOC
is a viable option for many, the borrower must then deal with a
variable interest rate. A suitable alternative to either is to make
additional principal-only payments that reduce interest costs and
result in owning the home outright even sooner.
At a time of rising home prices and low short-term
interest rates, borrowers are increasingly gravitating toward interest-only
mortgages. An interest-only mortgage requires only the payment
of interest and no repayment of principal in the loan's initial
years. As a result, the monthly payments are a fraction of other
loan products. But without repayment of principal, the borrower
is entirely dependent upon price appreciation to build equity. Since
many interest-only mortgages come with a low, but adjustable, interest
rate, making additional principal-only payments reduces future interest
costs and builds equity without the reliance on appreciation.
According to the IRS, more than two-thirds of taxpayers
do not itemize their deductions. Since more than two-thirds of households
own their homes, the overlap means that many homeowners are not
benefiting from the mortgage interest deduction. For taxpayers who
don't itemize, a mortgage rate of 6 percent actually costs 6 percent.
Rather than pursuing potentially higher returns -- and taking on
a commensurate amount of risk -- in other investments, borrowers
can earn a risk-free return by making additional principal-only
payments. The interest savings amounts to an attractive return on
investment in a time of low bond yields and deposit rates, and a
stock market making little headway. One note of caution is the accumulation
of equity through additional principal payments may further skew
household assets toward wealth tied up in the home.
While there are valid arguments for not paying ahead
on your low-rate mortgage, plenty of homeowners stand to benefit
by accelerating mortgage repayment at one point or another. It may
be a temporary move during the early years of an interest-only mortgage,
piggyback loan, or when paying PMI, or it may be in the final years
of the loan when little refinancing benefit exists.
Greg McBride is a financial analyst
for Bankrate.com.
For advice regarding your specific
situation, please e-mail one of Bankrate.com's
Q&A experts or visit the Personal
Finance Advice channel on Bankrate.com.
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