(This is Part 1 of a two-part series. Read Part 2, “Paying home loan biweekly can save thousands.”)
The roller-coaster ride provided by the subprime fallout has brought the “pay-it-off sooner” idea back to the front burner for many homeowners.
Baby boomers and older Gen-Xers, who took out home equity loans to help finance toys and trinkets ranging from second homes to supposedly high-flying stocks, have begun to understand that there is little extra cash in which to pad the nest egg when they are still making huge mortgage payments.
Yet other home buyers continue to pay their original monthly mortgage payment because they are lulled into the assumption that they are receiving a fat tax deduction from Uncle Sam. They think the situation is tenable because the annual Internal Revenue Service 1098 form that arrives from the lender shows big-time interest payments that make fat mortgage payments worthwhile.
Remember that home-loan interest deductions simply reduce your taxable income. They are not dollar-for-dollar tax credits that can be subtracted from your tax bill. If you have a $1,000 a month mortgage payment and are in the 15 percent tax bracket, only about $150 a month escapes being taxed in the loan’s early months.
Ethan Skyler, a Seattle-area entrepreneur who was so shocked at the amount of additional money it cost to finance the purchase of a work tractor that he wrote a software program to illustrate the difference nearly two decades ago, had an intriguing way of explaining the home-mortgage-interest tax deduction to consumers.
“The home-interest tax deduction is like taking a suitcase full of money to a bridge high over a river and throwing it up in the air,” Skyler said. “The number of bills you catch on the way down is equivalent to your home-interest deduction.”
While Skyler’s description of the mortgage-interest deduction may be a reach, so is the amount some taxpayers are claiming on their annual return. You can deduct interest only on the original amount of the loan at the time you refinance, plus $100,000. For example, let’s say you purchased your home 10 years ago for $100,000 and took out a loan for $80,000. Since then, you have paid the loan down to $20,000.
The house is now worth $275,000 and your oldest child needs college tuition. The house definitely has equity to tap, but your mortgage-interest deduction would be limited to the first $120,000 ($20,000 old loan at the time of “refi,” plus $100,000).
One of the first options “to save” often seems to be refinance, lower your monthly payment, and bank/invest the difference between the original payment and the new payment. There are three problems with this avenue: First, despite the best intentions, consumers rarely save the difference — and earn a rate equal to their mortgage rate from their new investment. Some pressing need (school, medical emergency, family reunion) always surfaces to suck away the extra money that was supposed to be saved or invested. Second, the plan to lower the monthly mortgage payments by refinancing quickly is washed away by the empty feeling that you’ll have to start all over again, thereby lengthening your mortgage commitment. Third, if you accept a low-rate, adjustable-rate mortgage can you make the monthly payments once the loan adjusts? That payment could be greater than your present payment.
Unless you are strapped with an immediate need for a large sum of money (medical emergency, pressing family need) the decision to refinance should be based on how long you will be in your house. Never, ever take out a larger loan only because you believe it to be a wise “tax-deduction” play.
So, what are some basic strategies and programs to pay off your home loan faster?
Simple prepayment: Financial advisers say their not-so-thrifty clients should take the money they would pay in refinancing fees — or their unexpected bonus — and apply the cash to the loan principal. The money would pay off the original loan faster and save interest.
A 15-year mortgage: This has become a popular alternative to the 30-year loan, especially for second-time buyers and boomers who can afford higher monthly payments. These loans carry interest rates about half a percentage point below the 30-year fixed rate.
Another popular pay-it-off plan that has resurfaced after years of a minimum-payment mindset is the biweekly payment option that allows borrowers to make 26 payments every other week instead of 12 monthly payments.
Next week: Do biweekly payments make sense … and are they really free?
To get even more valuable advice from Tom, visit his Second Home Center.