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Pay Off Your Mortgage Early?

New_House.jpgInterest. It's great when you get it, not so great when you have to pay it. You'll spend more on mortgage interest your than almost anything else in your lifetime, except taxes and possibly food. Well, you may be sending a few of your kids to Stanford, or maybe you've done well enough to get that new 124' Delta you've always wanted, but for most people, it's true. For example, if you have a $250,000 mortgage at 6%, you'll spend over $260,000 in mortgage interest over the life of a 30 year mortgage, assuming you put 10% down initially. Because of the mortgage interest tax deduction, the typical taxpayer will actually pay less. If you assume (you know what happens when you assume) a 28% marginal tax rate, you'll actually pay about $185,000 in interest instead of $260,000.

We've been fortunate to have historically low interest rates for the last few years, and many people have refinanced to take advantage of them. This has saved the average mortgage holder thousands of dollars in interest. Take the $250,000 mortgage example discussed above. In the past, most people would have a mortgage interest rate of closer to 8 – 9%. At 8.75%, that same $250,000 mortgage would have cost you over $400,000 in interest! That's why so many borrowers were clamoring for a refi over the last few years.

Paying off your mortgage early will not only will save you thousands of dollars in interest, but will get you debt free sooner as well. Taking our $250,000, 6% mortgage example above, simply paying an extra $150 each month will save you over $70,000 in interest over the life of the mortgage! You'll also pay off your home 75 months sooner. The extra payments go straight to principal each month. If you look at how much you're actually paying toward principal each month in the early years of a 30 year fixed mortgage, you'll get physically ill, so don't do it. Just kidding, you really should know.

The first year of the $250,000 example, each month's P&I payments are $1,498.88. The interest portion of the payments are over $1,200, leaving only $250 going toward your principal each month. Each extra $150 payment reduces your loan's principal more than half what a regular payment does. That means it is basically saving you from making 60% of a payment later. In other words, at the beginning of your loan, each extra $150 payment saves you almost $900! That's a pretty good return.

You'll get offers from your mortgage company or bank for their accelerated program touting the advantages of early payoff. They typically have you make a half payment every two weeks instead of once a month. Since there are 52 weeks in a year, you'll be making 26 half payments instead of 12 full payments. Half of 26 is 13, so you're really making an extra payment each year that goes entirely toward principal. As you can see from the example above, any amount that you can reduce your principal at the beginning of the loan dramatically reduces the mortgage interest you pay over the life of the loan.

You can make these extra principal payments yourself, so why enter your mortgage company's accelerated program? The answer is, in most cases, you shouldn't. For one thing, it reduces your flexibility. You can make the extra principal payments every month, but you shouldn't be obligated to on the bank's schedule. If you choose to participate in such a program, be sure the bank is actually contributing the extra amount toward principal each month. Make sure your get a payoff schedule from the lending institution, noting the actual date the loan will be paid, and your total of payments under the accelerated program.

Some mortgages include a prepayment penalty clause. If you were unfortunate enough to sign one of these, you'll want to carefully examine it to find out the actual terms and consequences to your wallet. If there is no prepayment penalty, the equivalent investment yield of your additional principal payments are equal to the mortgage interest rate. Put another way, if you're paying off your mortgage early, it's the same as investing your additional principal payment in some other investment that pays the same rate as the mortgage interest rate. Given that, there is another school of thought that says don't pay off your mortgage early. Use that money for investing. At today's interest rates, you're getting very cheap money. It's not likely we'll see interest rates this low again for quite some time. You have the unusual ability to take advantage of these historically low rates. If you can earn more than your mortgage interest rate as an investment return, this school of thought says you should do so, and invest the money you would have prepaid on your mortgage. This will allow you to take advantage of the time tested principle of leverage to increase your net wealth. Because leverage is such a powerful tool, you can generate substantial wealth using it to build your retirement.

Having a few hundred thousand dollars to invest is a sure way to get a head start on your retirement nest egg. You must be able, however, to get an investment return that exceeds your mortgage interest rate for this to be a smart move. While leveraging your home mortgage into a retirement nest egg can be a wise choice for some, it ignores the value of being debt free. Being debt free obviously has an effect on your monthly cash flow and your psyche. Many people experience a dramatically increased sense of well being and security by eliminating all their debt. You should also make sure you are eliminating your higher interest financial obligations as well. These should be eliminated first, in any case. There's no sense in making extra principal payments every month to keep yourself from paying 6% interest when you're paying 15% interest on credit card accounts.

Only you can decide if it is better for you to prepay your mortgage. Do you want to retire that debt early and save the interest? Or, is more advantageous to keep your mortgage and invest the money and/or retire other debt? A case can be made for both approaches. Get all the information and go the way that works best for you.

Getting a more favorable interest rate on your mortgage may halp change the equation for you. Below are some of the lowerst interest rates for borrowers with good credit from the nation's leading lenders, as of yesterday.




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Comments

To know that you have a roof over your head...to know that you have made that last payment...to know that you could lose your job tomorrow and wouldn't lose your house...these are powerful pieces of knowledge.

I think if a person has no revolving consumer debt of any kind, then has their house paid off, then they can go into any kind of business/real estate debt they wish in order to leverage themselves...just not the primary home- regardless of tax or interest rate advantage.

All true. The piece of mind you gain from true financial security is priceless. I just want ed to point out there are two competing schools of thought on the subject, and you'll get powerful and convincing arguments from proponents of both sides. If your house is paid for, and you've no other consumer debt, your debt to income and debt to asset ratios are superb. This will help to give you an outstanding ability to aquire credit if you need it for business purposes.

If you are going to invest in real estate, or any other business venture, make sure you have the appropriate corporate structure and possibly an LLC in addition. If you don't set everything up correctly, it is very easy for a litigant to "pierce the corporate veil" and go after your personal assets.
You don't want to lose everything youorked so hard for.

In many cases, the lender for a business loan or LOC will require a personal guarantee with your home as collateral. Try to avoid that situation if at all possible.

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