Second mortgages are a lot more common now than they were just a few years ago. There are several reasons for this – many people took out a second mortgage to make home improvements, consolidate their debt, or because they purchased their house with a small down payment and wanted to avoid Private Mortgage Insurance (PMI).
Regardless of the reason someone has a second mortgage, there is a near universal truth regarding second mortgages – they usually come with much higher interest rates. These higher interest rates can be deceptive because the monthly payments tend to be small, but stretch out for long durations, often as long as your primary mortgage, or up to 30 years.
Should you pay off your second mortgage early?
I recently received a reader question regarding his 2nd mortgage, and whether or not it would be a good idea to pay it off early. A condensed version of his situation is below:
I have a second mortgage which I am considering paying off early. Here is my situation:
- I recently refinance my first mortgage and am now paying about $1,680/mo (5.25% 30yr fixed). The total amount of the refinanced loan is $245,000.
- I still have a second mortgage of $28,800 (7.875% 30yr fixed) and I’m paying about $223/mo.
- I personal savings is about $70K which is only earning 1.9% interest.
- The second mortgage company is offering a promotion to give me $500 if I payoff my second loan.
Should I take money out of my savings and payoff this second loan?
I figured 7.855% vs 1.9%… I’m better paying off this second loan. But are there tax implications and possible other factors that I have not taken into consideration. What else should I consider??
Thanks for the question. There are several considerations – the interest you are currently paying, how much your savings is earning, what else you may need the money for, taxes, and peace of mind.
Financially, paying off the mortgage is the clear choice
The numbers don’t lie, and financially, paying the mortgage off makes sense by the numbers: not paying 7.855% interest beats earning 1.9% interest every day of the week. In addition, you get a $500 bonus as part of your lender’s promotion. Score!
If you want more proof of how the numbers will work for your situation just visit an online mortgage calculator and run the numbers (or use the numbers you provided). The lifetime cost of the second mortgage is over $80,000! ($223 * 12 * 30 = $80,280). I’m not sure how much of your second mortgage you have already paid, but paying off your mortgage now could save you close to $50,000, most of which is interest.
How much interest are you paying? Try this quick exercise to see how much of your debt payment is actually going straight to interest each month, and how little is actually paying off the principle.
Tax considerations of paying off your mortgage early
You can usually write off mortgage interest as a tax deduction, but honestly, the tax savings on the interest you are paying each month would be negligible compared to the interest savings of paying off your mortgage, plus the $500 bonus. It also doesn’t make much financial sense to continue paying money, just to save money. This is really a non-factor and shouldn’t affect your decision.
What else will you need the money for?
This is a big one. $70,000 is a nice chunk of cash, and it is probably enough to make you feel very comfortable in your financial situation (assuming your mortgage debt is your only debt and you aren’t drawing on that $70k each month to meet expenses). Many people recommend keeping a large cash cushion as an emergency fund, which can be used to help deal with any unexpected expenses that come along.
How big should your emergency fund be? That depends on your lifestyle, job security, risk tolerance, and many other factors. Many “financial experts” recommend 3-6 months of living expenses. If you kill that second mortgage in one fell swoop you will have roughly $40,000 left in your savings. If that still covers your emergency fund and any other major expenses you are expecting, then it might not be a bad idea to consider doing it – from a numbers standpoint.
Peace of mind
All of this brings us to the final consideration – peace of mind. Will you rest easier knowing you no longer have a second mortgage at a higher interest rate? Will the extra $223 in cash flow help with other financial goals? Or does having $70,000 in the bank feel better than paying off your loan?
Is it better to pay off your second mortgage early?
By the numbers, paying it off will net you the best result by far. Other benefits include increasing monthly cash flow which will allow you to replenish your savings or work toward other financial goals, and removing a debt from your life. If you really want to speed things up, pay off your second mortgage and use that extra money toward your primary mortgage each month – you will shave off almost 10 years of mortgage payments – and tens of thousands of dollars in interest.
But personal finance is about much more than just numbers. If you have a need for the funds or feel more comfortable holding on to the cash due to economic, professional, health, or other concerns, then by all means, do what is best for your situation.
Readers – did I miss anything, or do you have other ideas to consider?
{ 16 comments… read them below or add one }
Ryan, in your scenario of 7.875% mortgage vs. 1.9% savings, it certainly means one should start paying the 2nd down with the cash reserves.
However, is 7.875% a realistic HELOC percentage? What I did instead two years ago was use my $100,000 HELOC at 3.25% to pay down $100,000 of my principal of my first mortgage rate of 5.25% to arbitrage it out. I wrote about it in “Going Broke To Win Big HELOC Edition”.
I’d be surprised if HELOC rates are above 5.5%, since the Fed Funds rate hasn’t move in the past couple years. But, maybe people are letting banks screw them. and capture a fat spread.
FS, a HELOC and and second mortgage are two slightly different animals; the difference is a second mortgage is a fixed rate loan, and a HELOC is a revolving line of credit. Interest rates can vary depending on a multitude of factors.
I don’t know the full situation (I didn’t ask), but the reader mentioned he recently refinanced his primary mortgage at a lower rate, so it’s possible the buyer wasn’t able to get the lowest interest rate when he made the purchase. So if he refinanced to a 5.25% loan, then it’s possible his primary mortgage was around 6% or higher when he bought his house, and his second mortgage was the 7.825% as he mentioned. Either way, paying the second mortgage off now (either in full or by making additional payments) can make a huge impact on his bottom line!
And for the record, I’m more interested in where he is getting a 1.9% interest rate on his savings! The best interest rates I’ve been able to find are around 1.65%.
Gotcha. a 5-yr CD is offering 2.5-3% now.. so maybe that’s what he’s referring too.
7.825% is rough. He’s getting taken to the cleaners!
Even if he’s uncomfortable draining away all of his savings at once, he could still pay extra toward the principal each month, paying off the second mortgage earlier and saving money. As as Sam points out, he could probably find some sort of a refi to a lower rate to help things along.
The tax ’savings’ of having that additional interest to write off (taking the 7.87% against the full principal of 28.8K) is $560 (assuming the 25% tax bracket) – the bank is offering a $500 bonus, which after tax (as this counts as interest income) would still leave only a “loss” of $288 in taxes to pay – which is less than 2 months of the 2nd’s payment…Duh. I can’t imagine NOT paying it off with the cash reserves – unless there are other factors (anticipated big expenses or imminent layoff).
I forgot to mention that my biggest financial regret/mistake was consolidating unsecured consumer debt into a $15K 2nd mortgage against my house (first mortgage balance was at $135K against a $200K-appraised house). After my husband was laid off, we weren’t able to keep current on our payments for a few months while he was job-seeking, and foreclosure was a real threat. Almost losing the roof over my family’s heads over $15K of credit card debt … absolutely crazy stressful. Needless to say, we pulled ourselves out of that hole and paying off that 2nd mortgage is my number one priority/ even over higher interest, lower balance obligations.
Michelle, That is the perfect example of when to pay off a lower interest loan instead of a higher interest loan. I’m glad to hear things are working out now, and I wish you and your family continued success.
Ha ha – my first comment got eaten…I ran the numbers on the so-called tax consideration. Taking full interest on the 2nd (2250 or so) for a year and assuming a 25% tax bracket, the positive impact of the deduction is a tax savings of $563 – even if you tax out the $500 bonus that the banks is offering as interest income, you’re gaining $375 – so the overall ‘loss’ for the year the 2nd is paid off is $188 in taxes you’ll have to pay. Why pay a year’s worth of $223/month to save $188?
If his primary job is fairly secure, I’d definitely pay off that 2nd mortgage…
For me, I get a certain level of satisfaction not having any debt (although I wouldn’t mind having debt for business opportunities).
I have a home equity loan for $49,000 at a 8.5% interest, can’t refinance right now due to the drop on the housing market, my first loan is a 6% ( $199,000) I’m on my 2nd year of bancrupsy, so my credit score is none. any suggestions on how to deal with my situation, really need to get a better deal. Thanks
Your credit score isn’t none, it’s low.
Sorry man, but it sounds to me like this is the consequences of having filed bankruptcy. Your paying high interest because you need to earn the trust of people who are lending you money again.
Your only option is being responsible – living below your means, putting away extra money, dropping unnecessary extras in your life, paying down your loans, and earning back the trust over time. There’s no magic bullet.
I’m in almost the same situation, except my 2nd mortgage monthly payment is just under $200, and if I pay if off in less than 3 years from when I acquired it I have pay a penalty. The 3 years is up this May so I hope to have it paid off over the summer. If for no other reason but the psychological boost of now having it anymore!
I have a 15 year mortgage with a balance of 113000.00. I’m in the seventh year of the mortgage 8 years left. I also have a 30 year second mortgage 6.9 two years into it. I was looking at refinancing at 3,85 percent plus 3000.00 in points for a ten year mortgage. It saves me money on the second but I know it costs me on the first. Combining reduces my payment 150.00 a month. Is it worth it?
Joe, It seems like it will save you a lot of money in the long run, especially if you continue paying the same amount you are paying now – that additional $150/mo going toward the principal will make a huge difference and probably knock a couple years off your total mortgage.
Here’s an different twist… I have a 1st mortgage (fixed 4.875) with 114k left to pay over the next 9 years. I have a HELOC with a 324k balance (variable currently 2.25). I have enough money to pay off the 1st mortgage. Should I? I’d continue to aggressively pay down the 2nd – but it’s still interest only for the next 7 years so the payments could be flexible if need be. What are my risks? Tax disadvantages? Part of the HELOC is a business loan.
Lee, you have an excellent fixed rate on your primary mortgage, which would be tough to beat. The flexible rate is lower, but I don’t think interest rates will stay that low for long. It would be a huge gamble to do it.