This post is part 2 of 7 in a series entitled “When not to pay down your mortgage,” which outlines many scenarios where paying extra on your mortgage isn’t necessarily the best financial strategy.
For many years, making extra payments on your mortgage was generally viewed as an excellent investment. If you want to own your home “free and clear,” there’s no better feeling than seeing that principal number go down on your loan.
However, with mortgage rates at historical lows, it may be time to reconsider the value of making early payments or extra payments on your mortgage. If you have extra cash that you can do something with, mortgage payments are just one of many options. At a minimum, there are generally other financial steps you should consider before putting the money into a mortgage.
In a previous post, I considered the need to evaluate long-term inflation effects when evaluating payment strategies. But before you even worry about complexities like that, there are other more basic issues to consider.
Pay down expensive debt first
This should be obvious, but if you have high-interest loans or debt, you should start with the those debts with the highest rates. If you have a credit card you’re paying 25% interest on, it makes little sense to overpay on a mortgage that you’re only getting charged 5% on.
Similarly, if you have auto loans, student loans, or any other debts that have a rate higher than your mortgage, put your extra cash toward them before even considering an extra mortgage payment.
Some people might be tempted to still make payments on a mortgage over other debts because the mortgage value is so much greater. If you owe $100,000 on your house, shouldn’t you worry about that large balance over $5,000 on your credit cards?
Let’s consider that scenario in more detail, with a few simplifying assumptions. Suppose your mortgage rate is 4% (not uncommon these days), while your credit card rate is 15% (a middle-of-the-road rate, unfortunately, but very few are below 10%). And let’s assume you have $8,000 per year to devote to payments on your house and credit card debt. At these rates, you’ll need at least $4,750 per year just to keep up the interest.
Furthermore, just to simplify things further, suppose that beyond paying the interest on both the mortgage and credit cards, you use the rest of the money to pay principal down on only one of them. This is not a typical situation: most loans don’t allow “interest-only” payments, where you effectively never pay the principal down. But it’s the simplest assumption for our calculations. (For simplicity, I’ve also assumed here that interest compounds annually, so that the math is easy to follow.)
First, let’s look what happens when you put all your excess money toward paying down the mortgage debt, which has a higher principal.
- Starting Balances: $100,000 on mortgage, $5,000 on credit card
- Year 1: $4,000 interest on mortgage, $750 interest on credit card, $3,250 to pay principal down on mortgage
- Balances at end of Year 1: $96,750 on mortgage, $5,000 on credit card, total interest paid: $4,750
- Year 2: $3,870 interest on mortgage, $750 interest on credit card, $3,380 to pay principal down on mortgage
- Balances at end of Year 2: $93,370, $5,000 on credit card, total interest paid: $9,370
If we continue this pattern for ten years, you end up with a mortgage principal of $60,980, and our initial $5,000 remaining on our credit card. You thus owe a total of $65,980. Over the 10 years, you’ve paid $40,980 in interest.
Now, suppose we reverse the strategy and instead put all the excess money toward the credit card debt, with the higher interest rate (but lower balance).
- Starting Balances: $100,000 on mortgage, $5,000 on credit card
- Year 1: $4,000 interest on mortgage, $750 interest on credit card, $3,250 to pay down credit card
- Balances at end of Year 1: $100,000 on mortgage, $1,750 on credit card, total interest paid: $4,750
- Year 2: $4,000 interest on mortgage, $263 interest on credit card, $1,750 to pay OFF credit card, $1,987 to pay principal down on mortgage
- Balances at end of Year 2: $98,013 on mortgage, $0 on credit card, total interest paid: $9,013
Already, by the end of 2 years, we can see a significant decrease in the amount of interest paid. But suppose you continue the pattern for 10 years. Since you already paid off the credit card, you now continue paying down the mortgage principal.
At the end of 10 years, you end up with a mortgage principal of $60,423, and no balance on the credit card, so the mortgage is your total debt. Over the 10 years, you’ve paid $35,423 in interest.
There’s simply no comparison here. By paying down your credit card first, you would end up paying over $5,000 LESS in interest AND owing over $5,000 LESS in debts at the end of 10 years.
Obviously this example is oversimplified, but the strategy would be the same for loans in the real world. In general, you should always pay down the debt with the highest interest rate first, regardless of what has a higher principal. So, start with credit cards, student loans, car loans, whatever — as long as their interest rate is higher than your mortgage, pay them off first. If your mortgage does happen to have a higher rate than one of those other loans, you should perhaps start paying your mortgage. However, if this is true, you might also consider whether refinancing is a good option, which might be able to bring your mortgage rate down further and below the interest rates for other debts. (Whether refinancing is a worthwhile strategy can be a rather complicated thing to determine, which really depends on the individual terms of your loan: consult a financial planner to figure out whether this is a good option in your situation.)
One last comment: if you take no other lesson from this section, realize how ridiculously bad it is for your finances to carry credit card debt. Paying your credit cards off every month will likely have a much greater impact on your financial future than any overpayment you might make on mortgages or other loans. Make that the highest priority, and if you don’t have the discipline to keep zero balances on your cards, stop using credit cards as much as possible and use cash, checks, or debit cards.
An exception to the rule: Possible tax benefits
Even if the rates for another loan are equal or slightly less than your mortgage rate, it may still make sense to pay the other loan first. Why?
Consider the tax benefit of mortgage interest, which is deductible. For people with relatively small mortgages and little else to deduct, there may be little tax advantage in mortgage interest. But for those with large amounts of mortgage interest each year, it can provide a significant tax advantage, perhaps making your 4% mortgage rate effectively into a 3% rate. In such a case, you might still want to start by paying on other loans with rates greater than 3%.
The tax benefits of mortgage interest deductions are something to discuss with a tax accountant or a financial planner, and the advantages will depend on your specific financial situation and loan terms. But keep in mind that mortgage debt is often the last loan to overpay, even if it has a slightly higher rate than some other debt.
A final complicating factor: low equity or PMI
The previous analysis assumes that you have at least 20% equity in your home and aren’t paying for private mortgage insurance (PMI). Most of the time, PMI is based on a percentage of the mortgage principal. For very low equity in a house and bad credit, you might be paying 1% or more of your loan value in PMI.
As a general rule, you should add in the percentage of your principal paid annually to PMI to your interest rate. So, for example, if you have a 4% interest rate on your mortgage, but are paying 1% for PMI each year, that’s effectively a 5% loan rate. That’s the rate you should use when comparing it to interest rates on your other debts.
This is an oversimplification, but in some cases the PMI cost may a significant factor to consider. Also, if you know that you can reduce or eliminate the cost for PMI by paying down the mortgage slightly in the near future, it may be better to dedicate some money toward that goal before tackling higher rate debts. In general, credit cards are still the first thing to pay off, but if you don’t have credit card debt, an approaching PMI threshold might argue in favor of paying on the mortgage versus car loans, student loans, etc. However, this is really a question for a financial planner.
If you have excess money in the bank to pay down debts, congratulations!
But before you start a plan to donate an extra $100 or more automatically to your mortgage each month, first make a list of all of your loans and their interest rates. In general, devote your overpayments to the highest interest rate loans first, which often will NOT be your mortgage. However, if you are paying PMI or taking a mortgage interest tax deduction, you will need to factor that in your decision.
Go to part 3: Saving for retirement
Disclaimer: This is not intended to be professional financial advice, nor does it apply to all people in all situations. It’s a good idea to consult a professional financial advisor before making any major changes in your finance management, because individual circumstances will often affect the choice of strategy.