Paying off the mortgage early
Dear Dr. Don,
My wife and I are saving $3,000 a month. We are just putting this money into a savings account earning a little more than 1 percent. We have about $50,000 in this account. We have no debt, other than our house and one car payment. We want to use this money to pay off our house in four years. Is this smart or should we be doing something different?
Congratulations on having the income to afford a savings plan that allows you to put aside $36,000 a year in savings. Maintaining this discipline over time will allow you to reach your financial goals.
If your goal is to pay off the mortgage then it makes sense to make monthly additional principal payments rather than accumulate this money in a savings account until your savings account balance equals your loan balance. The money you save in interest expense outweighs the fairly meager return on your savings account. In fact, as long as the after-tax return on the money invested is less than the after-tax cost of your mortgage you’re much better off paying down the mortgage.
The after-tax cost of your mortgage depends on whether you can use the mortgage interest deduction when filing your federal and state income taxes. An approximation of this after-tax rate is your mortgage rate times one minus your federal and state marginal income tax rates. Here’s the formula:
Effective Rate = Mortgage Rate x (1 – federal tax rate – state tax rate)
Before you start prepaying the mortgage make sure that your additional principal payments don’t trigger a prepayment penalty on your mortgage. Review your loan documents to see if the mortgage has a prepayment penalty.
With no prepayment penalty, you can use Bankrate’s
mortgage calculator to see how making additional principal payments shortens the loan term and reduces your interest expense.
Your car loan is probably at a higher interest rate than the effective interest rate on your mortgage. If so, prepaying your car loan makes more sense initially than prepaying your mortgage. Again you need to make sure that there’s no prepayment penalty on the loan. Review your loan documents or contact your lender. You also want to make sure that the loan didn’t use the “Rule of 78s” to allocate the interest expense. A lender using this approach front-loads the loan’s interest expense and you pay an implied prepayment penalty by paying off the loan early.
This Bankrate feature has more on the “Rule of 78s.”
Take a look at the big picture before spending out your nest egg and allocating all of your monthly savings toward being debt-free. You should have an emergency fund equal to three to six months’ worth of living expenses in short-term investments that are easily tapped if you run in to a financial emergency.
Are you using tax-advantaged accounts for retirement savings? If not, why not? Assuming you’re not already retired, you can use these account to meet your retirement goals. The tax advantages can make these accounts a better choice than a taxable savings account.
Keep some money in reserve while working toward your goal of being debt-free. Along the way, pay down the more expensive debt first and then work on your mortgage debt.