Paying Down A Mortgage: A Great Way to Use Your Tax Refund?

  • Posted by Jordan Blakley
  • 03/19/2013
  • taxes
Paying Down A Mortgage: A Great Way to Use Your Tax Refund?

Each year between 60%-80% of Americans (depending on your sources) receive a tax refund. Undoubtedly, we can all find ways to spend some extra cash. But if you are looking to use your refund to improve your overall financial picture, than paying down the mortgage should be high on your list.

The Benefits of Paying Down Your Mortgage:

By making additional payments on your mortgage, you can reduce the amount of interest you will pay over the life of the loan. And the savings can be significant!

Years ago when interest rates were much higher, it was not unusual for the interest on a 30-year mortgage to exceed the principal. Even with today's low rates, a mortgage's full interest can still be hefty. For example, at a low rate of 4%, the interest on a $250,000 loan will be close to $200,000 - meaning the borrower may pay over $400,000 in total.

By paying down your mortgage early, you can make a significant dent in the interest you'll pay over time. This will allow you to build equity faster, enabling you to own your home sooner.

In addition, those who pay down their mortgage may also have the option of eliminating private mortgage insurance, or PMI. Remember, PMI is the insurance you must carry if you put down less than 20 percent on your home. With this in mind, it can make sense to send in extra payments when possible, as these will help you pay off that initial housing deposit and get rid of that pesky PMI.

Is This the Right Choice For Me?

Before you decide to send that nice refund check to your lender, make sure to weigh your options. Depending on your unique financial situation, there may be better uses for your tax refund, such as:

Creating an Emergency Fund:

Many experts suggest creating a cash cushion to cover unexpected expenses, such as a burst pipe or termite invasion. The goal is not to be cash poor when paying down your mortgage. Otherwise, you could find yourself borrowing more money at a much higher interest rate to handle an unforeseen financial crisis.

Maxing Out Your Retirement Accounts:

Whether it's a 401(k), an IRA, or some other type of account, maxing out your retirement savings should be a top priority. Putting in a substantial amount of money into your retirement fund can become even more beneficial if your employer promises to match part or all of your financial contributions.

Paying Off Outstanding Debt:

It's important that you focus on paying off all your debt obligations when considering sending in additional mortgage payments. Remember, credit card debt carries high interest, reaching 22% in some cases.

Watch Out for Prepayment Penalties!

In addition, while it can be helpful to send in an extra payment, it is important that you identify whether or not your loan has any prepayment penalties associated with it. Keep in mind, a prepayment penalty, or a prepay, is an agreement which regulates how quickly a borrower may pay off a loan. Frequently, borrowers are only able to pay up to 20 percent of their loan balance each year. If the homeowner exceeds that amount, they may be charged a prepayment penalty.

Therefore, make sure you ask your lender if there are any prepayment penalties associated with your loan before you send in any extra payments.

A Word to the Wise:

If you decide to use your tax refund towards paying down your mortgage, be certain your check goes towards your loan principal. Highlight any extra payments you make and tell your lender that you want that money to be applied to principal only. If you do not specify, that extra check could be mistaken as an early payment and may not be applied towards your principal amount. Therefore, we suggest writing a separate check for any additional payments you choose to send in. This will avoid any unnecessary confusion.

Additionally, make sure to examine your end-of-the-year statement to ensure that all additional payments have been applied as requested.

Last, deciding to pay down your mortgage is a decision that requires quite a bit of thought and planning. Please consult a financial professional for more information specific to your personal circumstances.