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.
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