Monday, May 12, 2014

Does it make sense to pay extra toward your mortgage?

Does it make sense to pay extra toward your mortgage?

The easy answer to that question is, “yes,” as it is factual you’ll save a lot of money on interest by making extra payments to your mortgage.  However, does the savings pack as much punch as you think, and under what circumstances is it not beneficial?  If you’re going to accelerate your mortgage payoff, is there a right way to do it? 

Why you should pay down your mortgage faster.

The mortgage payments you make are front-loaded with interest.  If you look at a schedule of your total payoff to $0 over 30 years (called amortization,) you’ll notice that the first payments are almost all interest to the bank.  Half of your payment won’t be going to pay off principal until around year 10 for most mortgage holders! 

Assuming you’ve got a $300,000 loan amount set at 4.5% on a 30-year fixed mortgage, even an extra $100 payment would save you $34,086 over the full loan term and shorten your mortgage by 3 years, 7 months.
How about if you could swing an extra $500 every month?  You’d be saving a whopping $107,912 and shorten your mortgage by 11 years and 10 months!
Why extra payments early on will save you so much

If you’re like most people when it comes to paying off your mortgage, you run counterintuitive.  You make normal payments for 10 years and then open their bill one day and see the principal edging down, and that’s when you get excited and start paying more aggressively.  Instead, you should pay more in the beginning to make the greatest financial impact.  Why? 

Don’t forget that interest on a mortgage is compounded monthly.  That means every month you’ll be charged interest not only on your existing principal balance but also on the previous interest that’s accrued.  So if you begin with a $100,000 mortgage at 5 percent annual interest, after one month, you will be charged 5 percent/12, or just under 0.42 percent, each month.  Therefore the longer you let interest accrue before paying down your loan, the more interest payments you’ll make. 

That accrued interest may not seem like a whole lot of money, but that same $1,000 plus interest will cost $1,004.17 after the first month, but will cost $4,467.74 over the lifetime of a 30-year mortgage.  An extra $1,000 paid in the first month will save you nearly $4,500 in the last.  You’re effectively paying down the principal amount that the bank can charge interest on, and also bypassing their amortization schedule that’s so front-loaded with interest. 

How can you calculate how much you’ll save with extra payments?

There are two ways to do this – the smart way and the smarter way.

The smart way is this:

To determine how much you'll save from an additional payment by dividing your annual interest rate by 12, adding 1, then multiplying it by itself for every month left in your mortgage: (1 + R/12)^M where R is your annual rate, and M is the number of months left in your mortgage. "^" means "to the power of," and is shorthand for "multiplied by itself this many times."

The smarter way is this:

Go to this calculator and plug in the numbers and get an answer.

How can you can pay extra?

Bi-monthly payments.
Instead of making one mortgage payment a month, you can set up your account to make a payment every two weeks.  That sounds like the same thing, right?  But because there are 52 weeks in the year, you’ll be making 26 bi-weekly payments, or one more full payment compared to a monthly schedule.  For most people, bi-monthly payments will shave 4-8 years off the life of the loan and save tens of thousands of dollars!

Write a bigger check every month.
Homeowners can also write a bigger check every month, with the extra amount going toward principal.  Some people just round up a few hundred dollars, while some add an extra 1/12 of the amount to each check, resulting in an extra payment every year, achieving the same outcome as bi-monthly payments.

Make a one-time yearly payment.
Some people prefer to write on bigger check to their mortgage company once a year when they get a tax refund, bonus at work, investment dividends, etc.  This can be effective but be careful – everyone starts out good intentioned, but discipline tends to fade when it’s tempting to use that month for a vacation, new televisions, or to pay off other obligations.  But if that’s the only way you can swing an extra payment, it’s better than nothing!

Who shouldn’t pay down their mortgage faster?

Paying a mortgage off quicker isn’t for everyone.  There are some situations that warrant a different course of action to achieve your financial goals.  Always check with your trusted financials advisors like your financial planner, tax professional, and insurance agent, before you finalize your plan. 

If you have credit card debt.
Keeping high credit card balances will cost you much more than the low interest rate on your home, which also may have tax benefits.  A lot of credit cards charge 20% interest or higher and come with hidden fees, so consider becoming credit card debt free before you start allocating extra money toward your mortgage.  However other debt like low-interest student loans may take a back seat to your mortgage.

If you have an upcoming tax bill.
It makes no sense to pay extra to your mortgage but then have a shortage come April 15, so make sure your income tax picture is in order, first.

If you don’t have enough savings.
It makes sense to amass a big safety net in savings before paying down your mortgage.  Experts recommend you put aside 6-12 months worth of expenses before funding investments or paying extra to your mortgage.

If you have investments that pay better.
If your mortgage is charging 5% with tax benefits, (called the effective rate) but you have some sort of investment that’s paying 10% return, for example, it may be wise to fund the investments, first.  Basically, you’ll be making more than the mortgage will cost you.  Utilize the principle of arbitrage by borrowing money at a low rate and investing it to earn a higher rate, or in this case, not throwing it at your mortgage.

If you’re employment is unstable or commission based.
If you have a job that yields peaks and valleys of income, you may want to fund savings more and pad your safety net before throwing more money at your mortgage to adequately prepare for the lean times.

If you plan on selling.
Here’s the kicker – if you plan on selling your home within the next 10 years, it may not make sense to pay down your mortgage faster.  Your money won’t necessarily be wasted, but assuming you go out and buy another home once yours is sold, you’ll be starting the amortization schedule of paying heavy interest from the beginning again, so those extra payments may be better allocated elsewhere.

If you are going to refinance.
Here’s the big one that people forget about; even if you plan on staying in the home forever, the average person refinances every 5 years or so.  That means a new loan with a new amortization schedule starting from scratch so just like selling, you may want to consider using the money for other beneficial financial instruments. 

Here are some other things to consider:

Pay early and often.
Like we pointed out, extra payments are most beneficial in the beginning of the mortgage. Why?  As we learned, interest compounds monthly and is heavily front-loaded, so the sooner you chip away at the principal amount, the less you’ll pay over the life of the loan.  

For instance, let’s say you have a 30-year mortgage at 5% on a $250,000 loan and pay $100 extra every month.  If you started making extra payments in year six of your 30-year mortgage, you’d save $15,095.21, and take 78 months off your mortgage.  But if you took only one year to start paying $100 extra every month, your total savings would increase to $20,989.55, and 96 months would come off your mortgage term.

Keep one eye on the tax man.
There are changes to the mortgage interest deduction laws, so consult your tax professional before setting your plan.

When life throws you a curve ball.
The other factor not highlighted here is flexibility.  If you pay extra into your mortgage and you then lose your job or have a divorce or medical disability and need the money, you can’t get it back.  However, if you keep the same dollars in some sort of interest-earning account that gives you flexibility to access it, you’ll be able to take out that money when you need it most.  That’s a huge factor in your overall financial picture that shouldn't be ignored.  

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