I suspect there’s no definitive yes/no answer here, but I’m hoping for at least some productive input…
So my wife and I own a house, have a mortgage, and have a chunk of money saved up in our checking account just from spending less than we take in. Obviously having money just sit in your checking account is a bad idea, so we’re considering taking it and paying down somewhere between 10% and 20% of what remains of our mortgage. What should we generally be thinking about to decide whether that’s a good idea or not?
Possibly relevant: we fully intend to move in 3 or 4 years… at that point we’ll presumably need to make a down payment on a new house, and house down payments are BIG (we live in Silicon Valley). If we pay down the mortgage by $X, and then when we sell our current house get $X more profit out of it, will that translate to having $X more to put into a down payment? That is, can one normally use the assessed-value-of-current-house-minus-amount-owed as part of a down payment? Or would that force us to fully sell the house first?
Also, what are the implications of paying down a chunk of principal vs interest?
What is your mortgage rate? What is your marginal tax rate, and how much less interest will you be able to deduct?
That tells you the effective “return” from paying down principle.
The risk is that the market and your situation might change and cause you to become upside down on the house and walk away. That is the only scenerio I see where you could lose the money.
Compare the return and risk to other investment options.
I’ve asked this question several times of different people with differing credentials, and majority opinion is to not pay extra against a mortgage under most circumstances. Generally, your mortgage loan is a lower rate than any other debts and probably lower than some good investments. In addition, if you have an emergency come up, it’s a lot easier to deal with if you have financial liquidity rather than try to get an equity loan.
Personally, I think the fact that you plan to move in the near future indicates you should minimize what you put into your house. Budget for primping it before it goes on the market, and keep the rest of your excess funds elsewhere. That’s my totally uneducated opinion as someone who has bought and sold far too many houses over the years.
Just for fun, I will calculate with hypothetical numbers. Lets say you have a mortgage at an annual rate of 4%.
If you pay off $50,000 and move out in four years, you’ll save $8,000 in interest. That’s 4% of 50k multiplied by four years. I did not account for the reduced principle over four years because that’s too complicated for me. This doesn’t account for tax deductions.
The real question is whether you can think of other things to do with the money that are better than saving roughly $8,000 in interest.
Can you qualify for another loan, and buy a new house without selling your current house? If you rent out your home you’ll make more than $8,000 in four years.
Make repairs to your home in order to sell it? The repairs might increase the market value by more than $8,000 (after expenses for repairs).
Forget moving and invest in mutual funds? You’ll make more than 4% if you can wait long enough.
Even if you can’t think of anything better to do with the money, I don’t think saving $8,000 is worth losing your savings.
The math for a mortgage is more complicated than that. Interest on a typical mortgage is front loaded so the age of the loan will have a lot to do with how much one can save by paying down a portion of the principal. For example, in the first year of a 30 year loan only about 30% of each monthly payment goes toward principal and 70% toward interest. In year 30 over 95% of the payment goes toward principal, only 5% to interest.
Also a consideration - the money in your checking account will be worth about the same in 3-4 years (plus any interest and less the impact of inflation). If you put that into your house the value will be subject to the real estate market. Should the real estate market slump/collapse in your area you could lose (or not be able to access for a very long time) all of the equity in your house, including the extra payment.
Short time windows generally call for a conservative financial approach.
When we moved to Silicon Valley we had no problem using the equity in the home we sold as a down payment of sorts - in that we didn’t finance that part of the new home. In today’s market you won’t have any problem selling - buying is another matter. But if you get an offer accepted you can arrange the closing so you carry the check from one to the other.
To summarize what others have said you need to consider
the tax deduction you give up on your interest not now paid, which effectively reduces the return of paying some of the principal off early
Alternative investments
liquidity
risk. Both for the value of your house and the value of the investments you’d buy with the money.
leverage. Not mentioned. We bought in Silicon Valley at a very good time. Subtracting principal payments, we owe about 2/3 the original prices of the house, but we owe about 1/4 of the current price of the house. So, our 33% equity has become 75% equity, all for more or less free. Paying more and you reduce leverage. You get out the same amount, but when you start considering psychological factors you should consider this.
I could put more into my house, but I prefer not to because my interest rate is low, tax rate is high, I like the liquidity, and my investments have been doing quite well. I also put some money in new floors, carpets and lighting, which both increases the resale value and makes the house better to live in.
So I personally would go with another place to invest the money, but some people are so into reducing that debt they want to put it in the house.
Though you don’t say it, I assume you have no other high interest debts, which would trump any of what I just said.