I am often asked if prepaying on a mortgage loan is best, and if so what method of prepaying is best. Paying off any debt is always a good idea as it increases net worth and eventually alleviates the borrower from paying a large amount of interest, but the priority of paying off a mortgage should be carefully considered.
The first thing I typically ask those interested in this question is whether or not they have any other debt they are currently making payments on including auto loans, personal loans, student loans, credit cards, or finance companies. The typical answer, based on yesterday’s post, Drowning in Debt, is yes. If that is the case then considering the outstanding balance, interest rate and payment on that debt will help in determining whether or not paying down the principal balance of your mortgage is smart.
As of today, Bankrate.com’s Interest Rate Roundup shows that the average rate for a 48 month used car auto loan is at 7.93% and the average fixed rate credit card interest rate is at 13.42%., while the average mortgage interest rate is 6.77% for a 30 year fixed mortgage. Simple math and some common sense shows that a 13.42% rate on your credit card is worse than a 7.93% interest rate on your car which is worse than a 6.77% interest rate on a mortgage. Paying off higher interest debt is smart choice in my eyes.
Outside of interest rate is the financial impact a debt has on the person paying the best. The payment should be considered when deciding on what debt should be paid off first, too. Consider a principal and interest mortgage payment on a $200,000 home at a rate of 6.77%. The payment would be $1,299.86/mo or .65% of the outstanding balance. Now let’s calculate a payment on an auto loan with a balance of $20,000 at a rate of 7.93% would be $487.60/mo or 2.4% of the outstanding balance. And lastly, the credit card with an outstanding balance of $7,500 and a rate of 13.42% is about $300/mo or 4% of the outstanding balance. When you look at these numbers it is easy to show that by paying off the credit card you will save the most money compared to the balance, followed by the auto loan and then the mortgage.
So far with two different ways of looking at it, paying off the highest interest rate debt will make the biggest impact to your short term financial situation and allow you to pay off other debt quicker. It sounds like that is the solution then – to pay off the highest interest rate debt, then the second highest and so on, right? Well consider other opportunities. Most companies these days offer a matching plan for a retirement account of 50% or even 100% for a certain percentage or dollar amount you contribute from your paycheck. So, if you contribute $100 towards your 401k matching plan at work and your employer contributes a 50% match, or $50, you just made 50% on your money. Would you rather save 6, 7, or even 14% on your debt or make 50-100% on your money? I think I would rather make 50% than save 14%.
Lastly, think about setting aside some savings before paying off any debt or contribution to your retirement. If you pay down your mortgage or contribute to retirement, accessing the money in a crunch will be difficult. What if you lost your job and you need cash now to pay for gas, rent or your mortgage, if you used all your extra cash to pay down the principal balance on your mortgage the only way to get that money is through selling your home, refinancing the mortgage or getting a home equity line. Most lender these days wont even look at lending you money if you don’t have a job. I suggest setting about 6 months worth of living expenses in a savings account as a “just in case” fund, so you can access it when, or if, you need to.
