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.  

15 Habits of financially successful people.

No matter who you are or where you’re from, you probably have the same financial goals as everyone else – to be comfortable and build wealth.  Lucky for us, we can learn from the habits and traits that successful people all share.  They have a certain relationship with money that allows them to get ahead, no matter what life circumstances, up’s and down’s in business, or fluctuations in the market they may face. Here are 15 habits that people who are well off and live comfortably all have.  They...

1. Diversify.

People who do well financially never put all of their eggs in one basket – they diversify their investments and income streams, whether it’s the stock market, real estate, or investing in their own company.  By diversifying, they minimize their risk and

2. Track and analyze their expenditures.

Financially successful people pay close attention to their financial picture.  They track all of the income and expenses, whether it’s by inputting them into a spreadsheet, saving receipts, or using tracking software.  This allows them to analyze their expenditures every month and reduce unnecessary or impulse purchases.

3. Live below your means.

Research consistently shows that the millionaire next door rarely is interested in showing off their wealth.  They believe in buying quality but then holding on to it for the long term, whether it’s their car or home.  They’re more interested in saving and reinvesting then throwing around “flash” money to impress other people and keep up with the Joneses.

 

4. Make moves for the long term.

People who live comfortably and amass wealth rarely are tempted by get-rich-quick scheme nor chase any shortcuts to wealth.  They don’t buy and sell assets frequently or expect short-term gains – they buy quality investments and hold them, with the eye toward cashing in way in the future or at least based on market fluctuations. 

5. Automatically save.

Not only do wealthy people save, but they save automatically.  Most often, putting a portion of their paycheck into savings is the very first thing they do, followed by funding investments and paying bills.  Savings isn’t an afterthought for the wealthy - it’s automatic.

6. Plan for every eventuality.

Financially comfortable people understand that life will throw them some twists and turns, and sometime tragedy, so they make sure they plan for all of it.  They get life insurance to cover their families, great health insurance locked in when they’re young, disability insurance, and leave a clear will.

7. Live within a budget.

Being smart with your money isn’t the same thing as being cheap or not having fun.  In fact, wealthy people often spend on vacations, luxury items, and fun for their families, but they plan it.  They budget carefully and exhibit the discipline to follow it, not giving in to impulse purchases.

8. Invest young.

One of the consistent traits of people who are financially comfortable later in life is that they started investing young.  Even in their 20’s or sometimes their teens, they understand the time value of money.  By putting money into 401k’s, Roth IRA’s and the like when they’re young, they benefit from compounding returns and a windfall as they get closer to retirement.  

9. Always have a solid emergency fund.

Financial planners always shake their heads at the lack of savings among Americans these days.  Despite all of our income, wealth, and big purchases like houses, boats, cars, etc., people still do not follow the golden rule of finances – ALWAYS have an emergency fund of at least 6 months expenditures (and a year is much better!)  There are so many people who look like they’re doing well but are one paycheck or a medical emergency or divorce away from losing it all because they don’t have an emergency fund.

10. Pay off bad debt.

One of the most important characteristics of financially stable and savvy people is that they abhor bad debt, which includes credit cards, installment loans, and any other high-interest type of debt (different than mortgages or business loans that serve a purpose.)  They understand that they’re basically renting money at an exorbitant rate, and all of the savings and investments are for naught if they’re giving the money right back through debt payments.  The first thing on any financial To Do list to analyze your debt load and come up with a viable plan to make extra payments, and “stack” or “snowball” principle, allowing you to pay them off aggressively.

11. Pay bills immediately.

People who are smart with their money never wait until the end of the month or the last days before the due date to pay their bills.  Every month, they pay all of their bills immediately, right after they automatically save and invest.  This eliminates interest charges and solidifies the financial discipline to budget carefully with what they have left.

12. Invest in education.

Being good with money doesn’t mean you have to be a financial planner or get a university degree in economics, but everyone should read books, magazines, and do their fair share of research.  No one is going to care about your money more than you will, and trusting slick-talking sales people or following hot financial trends and get-rich-quick infomercials are a surefire way to lose.  Instead, invest time and energy into knowing who to hire, what questions to ask, and the basic principles about the risks and rewards of investments. 

13. Set goals and plan.

Just like any achievements in life, setting tangible goals with concrete timetables and planning the action steps to achieve them is crucial to success.  People who are wealthy never get that way by accident – there’s always a history of goal setting and careful planning, along with consistent reevaluation of their plan based on changing circumstances.

14. Work with the best team.

Truly financially stable individuals want to work with the best financial planners, CPA’s and tax professionals, and attorneys they can find.  They understand that this may cost a little more, but it’s nearly impossible to get ahead with a second-rate team behind you.  They definitely resist the temptation to try and do everything themselves, which is about ego – not financial smarts. 

15. Focus on the right things.

It’s amazing to see a direct correlation with how someone lives their life and what they sow from it.  Financially comfortable people almost always understand that true wealth comes from things you can’t buy – their health, spending time with family, their faith, and giving back to charity and community.  Those are the things they cherish above all else, and somehow it helps the rest fall into place.

Will winning the lottery make you happy?

Most of you reading this are probably saying saying “Heck, yes!” right now, but studies cast a shadow of doubt on that premise.  In fact, people who win it big with the lottery (like the Powerball or mega jackpot – we’re not talking about a $50 scratcher ticket) often cite complications, problems, and issues in their lives that they never experienced before, causing a certain level of unhappiness.

With the odds of winning a big jackpot 1 in more than 175 million (about the same odds of you being struck by lightning or having identical quadruplets) its not likely you’ll have that problem, but still, 25 percent of the population say they play weekly.  In fact the more financially challenged the demographic, the more they play the lottery.

Studies show that lottery winners experience a rush of euphoria with winning, but that quickly retracts as problems with taxes, being targeted by predators, and family problems arise.

“Winning will release some pleasurable chemicals in your brain over the short term,” said Scott Bea, clinical psychologist with the Cleveland Clinic. “Unfortunately, your brain will likely revert back to the same old same old before too long.”

Lets look at statistics compiled from a survey of 34 national lottery winners:

Effect on Individual Happiness

Percent of lottery winner who were happier after winning: 55%

No effect on happiness:  43%

Are less happy:  2%

Of the 55% of winners who are happier…

Claimed they were happier because of improved financial security and fewer worries:  65%

Claimed they were happier because they could buy what they wanted and life was easier:  23%

Effect on Family Life

Percent who remained married after winning:  95%

Percent of winners who have given some money to their family: 83%

Percent of winners who’s family claims to be happier:  58%

Percent of family’s who claim to be less happy:  37%

Probability that new family wealth will be gone by third generation: 90%

Percentage of lottery winner who had spent their entire winnings within 5 years:  44%

Percent of winners who have gained weight:  32%

Percent of winners who stay in their same job:  48%

Percent of lottery winners who still play the lottery on a weekly basis:  68%

Percent of winners who have given some money to their family:  83%

Percent of families who asked lottery winners for money: 29 %

Average number of friends men winners gave money to:  3

Average number of friends women winners gave money to: 1

***

What’s the conclusion?  A person probably will not significantly more happy because of winning the lottery, but they do have the capacity to sink into life’s new problems.  Family problems, stress about maintaining wealth, and dealing with the greed of others are the particular leading causes. 

Empirical research in the field of psychology and economics has found that people do get happier as their income increases only up to the point where they are financially comfortable.  Statistics show that level is about $75,000, after which happiness and life satisfaction ratings level off.

We wish you luck playing the lottery next time, and hope you win it big – but don’t expect it to make you happy in life.