Some people say that paying off a mortgage early might not be such a good idea because banks will end up charging you a prepayment penalty fee. Is it truly worth it to pay off your mortgage early or should you just let your mortgage run its course and take 30 years to pay it off?
We’re going to help you demystify all the misconceptions and all the rumors you keep hearing from different people regarding the pay off of your mortgage.
First, we need to look into the breakdown of mortgage payments and that’s exactly what we’re going to do now. Keep reading!
1098 form
For those who don’t have a mortgage and you want to know what it is, a 1098 form it’s a form that the banks send at year end. This form is then used to declare your mortgage payments in your tax returns.
If you have investment properties, then you can take all the interest paid as a deduction. If you are a homeowner, then you have to check with your accountant as to what it is that you can do with that form and how it will factor into your personal tax return.
Amortization
An amortization is simply the spread of all the interest throughout the life of the loan, in this case a mortgage.
For example, if you have a mortgage that is 30 years long, what will end up happening is that for the first 15 years, you will pay more interest in the first half of that mortgage. Then from year 16 and on, you will start making more contributions towards your principal, meaning, more money is allocated towards the reduction of the debt that you owe and less money towards interests. It’s the way the banks have it set up. That’s just the way it works.
In the case of Lucelia, her monthly mortgage payment was $2,251.69. Out of that number, $2,000 was going towards interest and $251 was going towards the reduction of the principal. That’s just to give you an idea. If you need to see how a 1098 form looks like, and the origin of the numbers covered in this article, make sure you watch the embedded YouTube video.
“In 2019, I started my mortgage with a balance of $298,785.58 and every month, I made payments of $2,251.69 plus a little bit extra whenever I could. I only reduced my mortgage by $6,678. Isn’t that crazy?”
“I was paying $2,251.69 x 12 because that’s what you have in a year, and out of all of these payments, only $6,678 went towards the reduction of my mortgage. That means that my ending balance was $298,107.46. That’s quite a hefty number. The statement was showing that in one year, I paid $24,393.08 in interest.”
Payoff statement
It’s just basically a statement where it shows the amount of money that you owe in your mortgage, plus whatever interest that you have accumulated so far for that particular month, plus whatever prepaid penalty you have to pay for paying off the mortgage early.
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Getting an accurate pay off balance is important. Most people tend to think that their mortgage balance is whatever number they see on their statement, but that is innacurate. You need a mortgage pay off statement to see how much interest has accrued up to the date of your pay off.
Banks are in the business to make money. They not only want to get the interest that you have paid so far in your mortgage, but they also want to get an extra piece of you for paying off the mortgage early.
Why? Because you’re eliminating their chances of making money off of you for the next 30 years or so.
If you have a 30-year mortgage, you have to take the $24.393,08 and multiply it by 30. Imagine just how big that number is going to look like (again, watch the embedded video to better understand these numbers).
Lucelia: “My unpaid principal for that particular mortgage as of the month of September 2020 was $190,788.30 and the interest that has accrued so far, it’s going to be $1,310.08. That’s derived from this principal payment of $2,251.69.”
“Half of it or part of it, it’s going to go towards the principal payment to reduce the rest, but $1,310.08 is going to go straight into the interest.”
The prepaid penalty can range somewhere between 3% to 5%, sometimes, even more depending on the type of loan that you’re signing up for.
“In my case, the prepayment penalty for this particular loan was 3% of the unpaid principal. In this case, we’re talking about 3% of the $190,000”
You also have to pay a county recording fee. Why? Because they have to transfer the title from the bank’s name or the bank’s lien into your name or your company’s name so that way, it’s fully yours.
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In this case, if you wanted to completely get rid of the mortgage and have nothing to do with the bank ever again in the future, you would have to pay a total amount of $197, 864.02. How much are these fees? If I were to add $1,310, $5,723 plus $42, all of that will add up to $7,075.72 cents.
The prepayment penalty
To find out about your prepayment penalthy, if there’s any, all you have to do is call your bank and ask them for about your prepayment penalty. That will give you a sense of how much you will be paying in prepayment interest.
Depending on the strategy and depending on the type of mortgage, you might want to reconsider paying off the mortgage early. Why? Because things change depending on whether you’re looking to invest in your home or in an investment property.
If you have a residential property, all that money, it’s coming out of your pocket. When you have a commercial loan or a commercial investment, your mortgage payment is paid by your tenant because you collect rent.
Then whatever amount you collect, you’ll wind up using that money to make the mortgage payment, which means the interest rates or the interest in itself are being paid by your tenant.
If you have a commercial property, having that change in perception can help you look at things in a different way because:
- The mortgage payment is being paid by your tenant.
- The US tax code will give you an incentive to continue to pay that mortgage.
Why? Because, for example, if you have a rental income of $30,000 a year and you pay $24,000 (just to round the numbers) in interest rates towards the mortgage, that means the IRS is going to give you a break.
They will admit and recognize that you’re actually paying a mortgage and that money is going towards the bank. So instead of having you pay taxes based on $30,000, what they’re going to do is to have you pay taxes off of $6,000.
As an investor, you are getting an incentive (as a tax write off) to continue to pay that mortgage but when you are a homeowner, the incentives may change.
Of course, it’s always nice to feel like you don’t have any debt, that you don’t own any debt, and you can enjoy all the cashflow altogether. But the decision of keeping the mortgage, or paying it off completely will be up to you, and hopefully the information shared today will help you make an informed decision.
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