Should you build equity and pay off your mortgage faster?
6/15/2006Contributing Editor
Interest.com
We all know the faster you pay off a credit card the less interest you will pay. What many of us forget, however, is that the same rule applies to a mortgage. But paying off a mortgage early raises all sorts of questions that don t apply to most other types of debt.
When it comes to mortgages, we re usually talking about our single biggest regular monthly payment. Mortgage payments affect our income taxes, our future and our sense of security. They also affect our equity that portion of the house that is really and truly and financially ours.
Before we look at the pros and cons of paying off a mortgage early, let s look at what s involved. Some people reach a point when they actually have enough in savings or investments to write a check and pay off the loan. But for the vast majority of us, the only way we ll ever pay off the mortgage early is to either make extra payments, or larger ones.
If you make one additional mortgage payment every year 13 instead of 12 you can lop years off the life of your loan. That extra payment goes toward reducing the principal of the loan, thereby reducing the amount you owe. This reduces the amount you pay interest on. If you start making that extra payment in the first year, you reduce a 30-year mortgage to a 24-year loan, saving yourself thousands of dollars interest.
You can also add extra money to your check every month not only to reduce the principal, but also the amount of interest you will pay and the length of the loan. When you make a mortgage payment, you are paying all the interest on the unpaid balance of the loan that has accrued since your last payment. Here s an example. If you have a conventional 30-year mortgage for $200,000 at 6.5 percent, your basic monthly payment interest and principal and not counting taxes, insurance or any sort off assessments will be about $1,264 a month.
On your very first payment, roughly $1,083 will go to pay the interest on the loan; the remaining $180 and change will go toward paying down the loan. In month two you have a loan for $199,820. The interest on that is about $1,082. The remaining $181 and change, reduces the principal, and so on.
Every time you make an extra payment, you are reducing the total amount owed and the amount of interest you will pay each month for as long as you have that loan. Since the extra payment goes directly toward reducing the principal, you are also increasing your equity in the home.
If you were to keep that home and home loan for the full 30 years, it would cost you $255,088 in interest. If you were to add $500 to each payment, you would cut the life of a 30-year loan in half and turn it into a 15-year loan, pay $110,940 in interest, and save yourself $144,148.
Any extra payment you make increases your equity and reduces the total amount of interest you have to pay on the loan. Most lenders say extra payments have to be at least $10. Some require that it be larger.
Let s look at that same loan and add $100 a month. Do that and you d knock five and one-half years off the life of the loan and save nearly $56,000 in interest. You can look at your own situation at interest.com. Once there, click on the mortgage loan calculator button. Fill out the form with your loan amount and interest rate, and you can see what making regular or even occasional extra payments will do for you.
The question, however, is: Should you? And can you afford to do so? If you can, you have to ask yourself if putting extra cash into your home is the best use of your money. That is a very personal question. Let s say you have an extra $1,000. Would you be better off using that to pay credit card or other debt? Would you rather put it toward a vacation or make an extra house payment? Do you want to invest it in your 401(k) or a CD -- the kind that earns interest, not the kind you listen to, add it to the down payment on a new car, buy a new toy, or buy stock? Or, would you rather put that extra $1,000 into improving your home? This could make the home more pleasant to live in, more attractive, and actually add to your home s value, which also increases your equity. It is your home and your money. All you are required to do is pay the amount on your mortgage bill.
Then there s the whole question of income taxes. Mortgage interest is the single biggest income tax deduction that millions of Americans get to make every year. Are you losing anything there?
For the standard $200,000 loan we ve been looking at, the total interest paid in the first year would be $12,934. Send in an extra $100 a month you would still pay $12,897 in interest that first year. Make it $500 and your total interest for the first year is $12,752. Even though your equity starts growing immediately, the tax deduction is still there because the savings come later, as the total amount owed is further reduced. So in the first few years, you wind up with virtually the same tax deductions and more equity.
Now we get to the part of the equation that you can t use math on your personal attitudes and feelings. What about peace of mind? Some people take comfort in building equity, in knowing that more and more of their home really is their own. Many people also believe that over the long haul, real estate will outdo bonds, CDs and the stock market in terms of a return on their investment and in peace of mind. It s your home, your home loan and your choice.