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Should I Use My Tax Refund to Pay Down My Mortgage?

02/15/2018 Kristin Demshki

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Nearly 80% of Americans receive a tax refund every year, averaging about $3,000 per filer. We can all find ways to spend some extra cash, but how can you take full advantage of your refund? Depending on your financial situation, paying down your mortgage could be a great option.

When It Makes Sense to Pay Down Your Mortgage

Before you decide to send that nice refund check to your lender, make sure to weigh all of your options. Paying down your mortgage with your tax refund makes more fiscal sense for some homeowners than others. It typically makes sense to use your refund to pay down your mortgage if:

You Don’t Have High-Interest Debt

It’s important to focus on high-interest debt obligations first. Credit cards carry high interest (reaching 22% in some cases!), so it’s wise to pay those off first. Credit cards and other high-interest debts can quickly become a financial burden, so they should come before paying down your mortgage early.

You Have a Strong Savings and Emergency Fund

Having a cash cushion to cover unexpected expenses is a great step toward a stable financial future. Whether it’s a burst pipe or a termite invasion, all kinds of unforeseen costs can come out of an emergency fund. The size of the emergency account will depend on your situation, but it’s advisable to have at least a few months’ salary set aside. (Otherwise, you could find yourself borrowing money at a much higher interest rate to handle a financial crisis.)

Your Retirement Accounts Are Maxed Out

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 a substantial amount of money into your retirement fund is even more beneficial if your employer matches part or all of your financial contributions.

Benefits of Paying Down Your Mortgage

If you’ve taken care of your high-interest debt and you have money set aside for the future, you can start thinking about paying off your mortgage early. By making additional payments on your mortgage, you reduce the amount of interest you will pay over the life of the loan—and the savings can be significant!

Back 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, the full cost of interest on a mortgage can be hefty. For example, even at a low rate of 4% on a 30 year mortgage, 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 and own your home sooner.

In addition, those who pay down their conventional 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. PMI can often be cancelled once the borrower reaches 20% equity in their home. With that in mind, it can make sense to send in extra payments when possible, which will help you pay off the initial housing deposit and get rid of that pesky PMI.

Different Ways to Pay Down Your Mortgage

If you decide paying down your mortgage is the best way to spend your tax refund, there are two different ways to do it:

Refinance your loan: One way to put your tax refund to use is to refinance your home loan. Refinancing your loan means replacing your existing mortgage with a new loan for the amount you currently owe. If you use your tax refund to cover closing costs and other refinancing fees, you can end up with smaller monthly payments and/or a lower interest rate for the rest of your mortgage term.

Make a one-time payment: You can make a one-time payment toward your principal to reduce the principal balance of your mortgage. This one-time payment will likely reduce the length of your loan, rather than reducing your monthly mortgage payment. (If you are interested in reducing the monthly payment itself, consider refinancing instead.)

If you make a one-time payment toward your mortgage, make sure your check goes toward your loan principal. Highlight any extra payments you make and tell your lender that you want that money to be applied to principal only. Otherwise, that extra check could be mistaken as an early payment and may not be applied towards your principal amount. (One way to avoid confusion is to write a separate check for any additional payments you choose to send in.) In addition, make sure to examine your end-of-the-year statement to ensure that all additional payments have been applied as requested.

Look Out For Prepayment Penalties

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.

Use Your Tax Refund to Your Advantage

At the end of the day, the best way to spend your tax refund depends on your unique financial situation. But if your financial affairs are in order and you’re in a good position to pay down your loan, your tax refund might be the best way to do it!

Interested in learning more about how to manage your mortgage to meet your long-term financial goals? Call a PennyMac Loan Officer today to discuss your options.