As of March 25, taxpayers have received over $200 billion in refunds during the 2016 tax season with the average refund being $2,866.If you’re one of many who received a refund check this year, you’re probably wondering what to do with it. Your first thought could be to escape to the Caribbean for a week. After all, who doesn’t want some spring time sun?
But, if your second thought is to pay down your mortgage with the excess cash, here are some things to think about first:
There’s one instance where using a cash windfall to make an extra mortgage payment can be a bad idea: When you don’t have an emergency fund.
The amount you should have in emergency savings depends on your income level. It’s a good idea to have at least 3 to 6 months worth of living expenses in savings. This fund is money you can dip into if something unexpected happens like job loss or unforeseen medical bills.
The problem with using a surplus of cash like your tax return to pay off your mortgage instead of saving is when an emergency comes up you’ll have to fall back on more debt. Credit cards and other debt vehicles can have an even higher interest rate than your mortgage. This could create a never-ending cycle of indebtedness.
If you decide to put your tax refund into savings, you can always increase your mortgage payments by a few hundred dollars each month which over time can still help you pay off the mortgage early.
Say you do already have an emergency fund.
The advantage of using your tax return for an advance mortgage payment is putting a dent in your principal. Paying down principal ahead of the payment schedule can decrease the interest you pay long term even if you pay ahead in small amounts. Make sure if you do make an advance payment that your payment goes directly to principal and not interest. You may have to contact your lender to instruct them on where to allocate the funds.
In addition to saving money in interest, if you have PMI (private mortgage insurance), paying off your mortgage to the 80% mark can qualify you for an early removal of PMI.
There can be one disadvantage of using your tax refund for advanced payment. Depending on your mortgage contract, you may owe a fee for prepayments. Check with your lender to ask about fees. You could end up losing more than you gain using your tax refund for an extra payment if you have to pay a fee for it.
If you do find out that your mortgage has some unfavorable terms like a high prepayment penalty or you now qualify for a better interest rate, it could be time to refinance.
Interested in learning more about your mortgage options or prequalifying for a home loan?