After the last round of refinancing, our primary residence mortgage rate is now at 4.25%. At this interest rate, I have to ask – Should we make extra payments? The original plan was to keep paying the same amount that we were paying before the refinance so the house will be paid off quicker, but perhaps this is not the best thing to do with our extra money.
Let’s make a quick pro and con comparison list to help us decide.
Extra Payment Pros:
Feels good. It feels good to pay down the mortgage every month. We don’t like owing money and it’s great to see the principle reduced visibly every month. It would be really great to own the home outright and not have to write a monthly check to the bank. This would free up our cash flow even more.
Less interest. Let’s look at an example. If you owe $200,000 @ 4.25% interest, then the monthly payment will be around $1,000. Paying an extra $200/month will save you about $50,000 in interest and the loan will be paid off almost 10 years earlier. This is very compelling to me. I don’t want to give the bank any more money than I have to.
PMI. If I had to pay private mortgage insurance, I would make extra payments until the PMI is eliminated. Fortunately, we are not paying PMI at this time.
Extra Payment Cons:
Saving and investment. The main argument against making extra payments on the mortgage is that you can invest that money better elsewhere. The 401(k), emergency fund, 529 saving plan for college, Roth IRA, and insurance are all better places to invest than the mortgage. We have a beefy $50,000 emergency fund and are already covered in these remaining items so we can eliminate this argument. Can I beat 4.25% by investing in the stock market or elsewhere? It’s possible, but not guaranteed. In the short term, you may not beat 4.25%, but I’m pretty sure in the long term, the stock market will do better than that.
Tax deduction. It’s great to have mortgage home interest to add to the tax deduction. Sure, the tax deduction alone is not a reason to buy a home, but we’ll take advantage of it while we can.
Home value. At this time, our home is worth about as much as what we owe the bank. If the home value keeps dropping, it does not make sense to pay down the mortgage. Why pay extra if the home will be underwater? Let’s say the home price continues to drop for 5 more years and we need to move. It doesn’t matter how much you prepaid if the home is underwater. We will still have to do a short sale or a strategic default.
Inflation. Let’s continue with the $200,000 mortgage example. In 10 years, that $1,000 dollars payment will feel like $500. In 20 years, that $1,000 will be equivalent to $250 today. Isn’t it better to wait as long as you can to make these payments?
After listing all the pros and cons, it is still difficult to see what is the right thing to do. My plan is to keep paying the same amount that we were paying before the refinance while we can. These extra payments at the beginning of the loan make a big difference in the amount of interest paid. Once I leave my day job, then we probably will make fewer extra payments.
What about you? Did you refinance and will you make extra payments at this low rate? I’m sure we will see 5% CD again in the future. Wouldn’t the money be better off in an investment account?
photo credit: flickr – nikcname
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