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Nearly 80% of Americans receive a tax refund every year, averaging about $3,213 per filer. How can you take full advantage of your refund? Depending on your financial situation, paying down your mortgage could be a great option.
Using your tax refund to pay down your loan principal can speed up your mortgage payoff and potentially save you significant interest over time. However, it may not be the best option for you. Let's explore when it makes sense, when it might not be the best strategy and how to assess your options and maximize the benefits of your refund.
When It Makes Sense to Pay Down Your Mortgage with Your Tax Refund
Before you decide to send your 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’s typically a good choice if:
You Don’t Have High-Interest Debt
Prioritize paying off high-interest debt, like credit cards, which can have rates as high as 22%. These debts can quickly become a financial strain and should take precedence over paying down your mortgage early.
You Have a Strong Savings and Emergency Fund
A cash cushion to cover unexpected expenses is a great step toward a stable financial future,many unforeseen costs can be managed with an emergency fund. The optimal size of an emergency account will depend on your situation, but it’s advisable to have at least a few months’ salary set aside to avoid borrowing money at high interest rates.
Your Retirement Accounts Are Maxed Out
Whether it’s a 401(k), an IRA or another type of account, maxing out your retirement savings should be a top goal. 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 Faster
If you’re clear of high-interest debt and have money set aside for the future, you can start thinking about paying off your mortgage early. Allocating your tax refund to your mortgage has two key advantages: saving on interest and building equity.
Interest Savings Over Time
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.
With a standard 30-year fixed-rate mortgage, borrowers often pay more in interest than in principal over the loan’s term. Paying down a significant portion of your principal allows you to reduce the balance faster, which in turn lowers the total interest you pay.
Build Equity Faster
Home equity is the difference between the current value of your home and the amount you still owe on your mortgage–the percentage of your home you actually own outright. For example, if your home’s current market value is $500,000 and you owe $200,000 on your mortgage, you have $300,000 in home equity. As a percentage, this is 60%.
Any money you put toward your loan’s principal balance can help you build equity more quickly. And the more home equity you have, the greater financial flexibility you gain. That’s because home equity can be a valuable asset, providing access to funds for various needs like home renovations, a major expense or even starting a business.
Possibly Eliminate Mortgage Insurance
If you're currently paying for private mortgage insurance (PMI) on your conventional loan, using your tax refund to pay down your mortgage can be a good move. Remember, PMI is the insurance you must obtain if you put down less than 20% on your home. PMI can often be canceled 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 additional monthly premium expense.
Applying Your Tax Refund to 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:
Make a One-Time Payment
You can make a one-time payment toward your principal at any time to reduce the principal balance of your mortgage. This one-time payment will likely reduce your loan's length rather than your monthly mortgage payment. (If you want to reduce the monthly payment, consider refinancing instead.)
If you make a one-time payment, ensure your check goes toward your loan principal. Highlight the extra payment on your payment slip and tell your lender you want that money applied to only the principal. Otherwise, that extra check could be mistaken as an early payment and may not be applied toward your principal amount. One way to avoid confusion is to write a separate check for any additional payments you send in. Many lenders also offer convenient online portals or apps for making extra principal payments.
Increase Monthly Payments
Use your tax refund to increase your monthly payments throughout the year. For example, if your refund is $3,000 and your monthly payment is $2,000, you could divide the refund by 12 and add that amount ($250) to each monthly payment for the year. Again, whether you pay by check or online, specify that the extra funds are for the principal.
In addition, make sure to examine your end-of-the-year mortgage statement to ensure that any and all additional payments have been applied as requested.
How advantageous are extra mortgage payments? Use our mortgage calculator to see the potential impact on your interest savings and loan payoff timeline.
Understand Your Mortgage Terms
Sending an extra mortgage payment can be helpful, but first, ask your lender or review your loan documents to check for prepayment penalties. A prepayment penalty, or prepay, limits how quickly you can pay off a loan. Often, borrowers can only pay up to 20% of the loan balance annually. Exceeding this amount may result in a penalty.
Make the Most of Your Tax Refund
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 managing your mortgage to meet your long-term financial goals? Contact a Pennymac Loan Expert today to discuss your options.
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Meet Our Contributing Editors
Bradley Thompson and Afton Lambert are Contributing Editors for Pennymac’s consumer content and are exemplary leaders within the mortgage industry space. Both experts take pride in helping our customers achieve and sustain their aspirations of home.
For over 13 years, Bradley has achieved success as a high performer in various leadership roles including consumer direct sales and mortgage fulfillment positions.
With over 10 years of mortgage experience, Afton started her career as a top performing Loan Officer, before transitioning into her leadership role, where she has recruited, hired and trained Loan Officers.
