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March 5, 2000
For most people, financing a home will probably be the single most significant financial obligation they make. Over the term of the loan you will receive many benefits from owning your own home, but not without a price. By the end of your loan term, you may discover that you paid twice as much for your house. This additional cost is a motivating factor to quickly pay off your mortgage, but surprisingly, paying off your home loan may not always be the smartest financial move. So before you pay off your home mortgage consider these important factors:
1) Return on Investments vs. Loan Rate
2) Type of Loan
3) Loss of Tax Deduction
1) Return on Investments vs. Loan Rate
In the tricky game of investing, it's all boils down to "return" -- how much money you will make on your investment principal. Of course, the more the merrier! Because interest rates have been very low over the last several years, most homeowners have low interest rate loans. (tip: if you don't have a low interest rate, you should consider refinancing your loan) The stock market, on the other hand, has been performing extremely well lately and many people are receiving high returns on their investments. So if your investments are yielding you around 20% and your home mortgage rate is only 8%, why pay off or pay down your home mortgage and forego a 12% return (the difference between 20% and 8%). As long as your investment return exceeds your loan rate, by a healthy margin, it may make more economic sense to place your available cash in good sound investments rather than pay off your mortgage.
2) Type of Loan
As you are aware, all loans are not created equal. Some loans are set up to readjust every time you make an extra principal payment and some do not. Typically fixed loans (loans with a fixed interest rate for the term of the loan) will not readjust after principal payments and your monthly payment will always stay the same until you pay off the loan. Adjustable loans may either readjust every time you make an extra principal payment or at designated times, such as the scheduled date the loan rate adjusts. First you need to carefully read your loan agreement and determine what type of loan you have or call customer service for clarification. The problem with loans that do not readjust after extra principal payments is that you receive NO benefit from periodically paying down the loan. Even though your principal balance may be lower, you will still pay the same amount of interest as you would if the principal balance was higher. So rather than make extra principal payments throughout the loan term, save all your money until you can pay off the loan completely. Only when the loan is 100% paid off, do you stop incurring interest and receive any benefit from paying down the principal balance. For loans that adjust only at designated times, make sure you schedule your extra principal payments to coincide with the adjustment date to receive the maximum benefit from your principal payment. If your loan readjusts every time you make an extra principal payment, it is smart to make extra payments as often as you can. Go ahead and add an extra principal payment with your monthly payment. With each principal payment, you'll receive the benefit of a lower mortgage interest.
3) Loss of Tax Deduction
Because home mortgage interest is a very good tax deduction (one of the few we have left), consider the effect on your taxable rate of the reduction or loss of the mortgage interest tax benefit. This should also be included in the calculation of whether to pay off or pay down your home mortgage or invest any available funds. With the combination of the low loan rate and the tax deduction, it may be better to invest your money rather than pay off your loan.
So before you send in that extra principal payment, make sure YOU receive the benefit and not the mortgage lender.
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