Should You Prepay Your Mortgage?
Published on - June 27th, 2006 (Modified on - August 3rd, 2006) (by J.D. Roth) You can save tens of thousands of dollars by prepaying your mortgage. But is it a smart move? A CNNMoney reader asks expert Walter Updegrave:
The psychological freedom of not having a mortgage is very appealing to us, but the argument for trying to invest the extra cash at a higher rate is compelling too. What’s your take on paying off the mortgage early?
Surprisingly, this is one financial point on which the experts do not agree. Updegrave says:
My advice is to first make sure you’re maxing out your retirement savings plans and make sure you’re on track toward a comfortable retirement. Once you’ve got that front covered, you can start paying off that mortgage more quickly to reap those psychological benefits you find so appealing.
Your Money or Your Life encourages readers to pay off mortgages early. Ordinary Wealth, Extraordinary People says not to pay them off early. Dave Ramsey, in The Total Money Makeover, advises that people put 15% of their income toward retirement savings before tackling their mortgages. (Though he does encourage people to pay off their mortgages early, when possible.)
In The Laws of Money, Suze Orman says just the opposite. She doesn’t care about tax write-offs. She doesn’t care about potential gains in the stock market. Paying off your mortgage offers a guaranteed return on investment: “You cannot live in a tax return. You cannot live in a stock certificate. You live in your home.” Orman says to invest in the known before the unknown.
The authors of All Your Worth suggest a combined approach: 10% of your income to retirement, 5% to paying down your mortgage, and 5% to save for future dreams. “Paying off your home also does something many financial planners neglect to mention: It gives you freedom. Once that mortgage is gone, just imagine all the freedom in your wallet.”
In Wealth Without Risk, Charles Givens offers a novel approach to prepaying a mortgage. “On the first of the month when you write your regular mortgage check, [include extra] for the ‘principal only’ portion of the next month’s payment.” Using my own $1625.65 mortgage payment as an example, $239.55 is designated for the principal. If I were to make a payment of $1865.20, I would be making approximately an extra monthly payment! If I do this every month, I’m cutting the term of my loan in half.
If you do decide to accelerate your mortgage payments, try to do it on your own, whether you pay one full extra payment during the year, or pay 8% extra every month. Banks often charge an fee to add this as a formal service, but you can do it for free yourself!
This article is about Choices, House and Home, Planning
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[...] J.D. writes on his Get Rich Slowly about whether or not you should pay of your mortgage. It comes down to the fact that experts don’t agree and you should decide for yourself. [...]
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I’m not sure I understand why the Givens suggestion is novel – I thought this was the basic idea of paying down one’s mortgage: anything you pay above the minimum goes straight towards principle, and since principle is usually a small fraction of your total payment, a small percent increase in payment shortens the total duration of the note noticibly. It’s not like the other people are suggesting that you pay extra interest or something, right?
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Ah, I should explain *how* it’s novel.
I’ve heard a couple a few different methods for accelerating mortgage payments. The first, and most common, is to just make an extra mortgage payment once a year. The second, which is a variation of the first, is to take this extra mortgage payment and divide it into twelve equal installments, and to pay this every month. I’ve also heard the suggestion that you just pay 10% extra every month.
Givens’ suggestion is novel because what he’s saying is that *every* month you should pay one extra installment on the principal. At the beginning of the loan, this will be a small amount. But as time progresses, this amount will increase.
Actually, his method is slightly more complex than this. I tried to simplify it for this entry. I think that it’s worth an entire entry on its own, though, so I’ll try to post it in the next day or two…
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When I look at people I know who have retired, the ones who have paid off their mortgages are much better off than those who haven’t. If your mortgage falls beyond you’re reaching 65, I’d say do all you can to pay it off early. If not, do what makes you feel more secure.
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I think the decision really depends on the situation you’re in. For instance, if you know that you’ll probably be moving to another area in a few years and the local real estate market is good – then it doesn’t make much sense to pre-pay the mortgage.
However, if you’re wanting to stay in the area, move up to a larger house, and maybe keep the house you have now for rent – then it might help not to have so much borrowed money on your new rental property. Buy paying off the bulk of your mortage, you can be more flexible in the rent that you offer.
Just a thought.
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There’s some variation between Canada and the USA with regard to mortgage terms. Here in Canada, most lenders have a lot of flexibility regarding prepayment options.
I prepay my mortgage in two ways:
1) I’m on an “accelerated biweekly” payment schedule, with payments made automatically every two weeks on my payday. This schedule means that every two weeks I pay one-half of a “standard” monthly payment. In a year, I’ll make 26 of those payments, or the equivalent of 13 monthly payments in 12 months.
2) I pay an extra $100 toward the mortgage with each payment.
The combined result of these options is that my mortgage, originally amortized over 25 years, will be paid off in approximately 15 years.
I’ve never understood why people would want to pay a mortgage monthly when they usually receive their paycheques every two weeks. I find it much easier to budget things when the regular bills coincide with the regular paydays.
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Absolutely not! Do not prepay that mortgage.
There are so many reason not to I hope I remember them here.
1) As you prepay in good times, you can’t ask for those prepayments back in bad times or expect favorable treament.
2) The prepayment goes to the backend of the loan. Your $1 pays off the last $1 you’ll pay in the 360th payment.
3) no tax benefits.
4) you are using current money to pay for future payment in 30 years. That is crazy.
Your extra $1000 could be worth $2500 in 30 years. But you get credit for $1000.
5) only way to undo it is to get a second mortgage.
6) your house appriciates or depreciates whether you prepay or not. so it’s meaningless.
7) you can do better things with $1000 than to prepay. You can put that $1000 in a 10 year bond or CD and use that $1600 to pay one payment in the 10th year.
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sorry for another post but I forgot something.
the value of money due to inflation means $100 in 30 years is worth less than $100 this year.
a hamburger will cost $10. A Honda will cost $50k. But your mortgage will still be $1234.
Your pay will increase but the mortgage stays the same.
also, the point of the interest % is that you buy time with the interest. time = money. there are very little things in this work that lets you get away with a 30 year payment at only 5%-6%. Ask your brother. Or sister. If you can borrow $100k for 30 years and pay only 5% interest. 5% interest is the deal of the century. Don’t slaughter this golden goose by prepaying it.
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We pay extra towards principal each month but are starting to cut back. The biggest issue for us is that no matter how much you pay off, the bank still expects its check each month, even if you’re unemployed or sick.
We’d rather have the extra money available for home additions, emergencies, or just dropping out. Like when I run away from the computer industry to start a business, or take a pay cut and become a teacher…
Or not. Still, it’s nice to have the buffer just in case the urge arises.
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Dokaben, my point exactly.
I heard this story on the radio one day.
An Airline machanic had this mortgage that he coverted to a 15 year loan so he can save money. His monthly went up of course. And on top of that he padded it up with an extra $100 or so a month. Until 9/11. Airline industry goes to hell. He almost lost his job. But managed to save it by taking a pay cut. Now he can’t meet the mortgage as well as daily his expense. He reveal he also has a credit card debt. The radio host’s advice was to get a second job to pay continue paying the mortgage and pay off the debt.
You can see the fixed mortgage payment as an enemy or a friend.
With inflation and a buffer in the bank, you can make it your friend. Ask someone who is paying off their 30th year of their mortgage. You may be shocked that their payment is not even half your current mortgage. That is what inflation and a fixed mortgage can do.
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I think the answer on paying down your mortgage has to be different for everyone. What’s your mortgage rate? Do you have a retirement account set up and are you contributing to it? What can you make on other investments if the money doesn’t go toward your mortgage?
My mortgage rate is about 5.75%, so I look at any extra payment as a guaranteed 5.75% return. So I look at that as part of my portfolio of investments. If my retirement is funded and I have extra money to invest, some piece of it may go to my mortgage as part of a plan to diversify–a chunk of money in higher-yield, higher-risk investments, a chunk of money in no-risk, lower-yield investments.
I like to pay down the mortgage a bit for psychological reasons, but the one big downside already alluded to is that your mortgage is not liquid. Paying it off feels good, but if you haven’t created a cushion with an emergency fund, you could find yourself wishing you could get your hands on some of that money, and the only way to do so is to then get a home equity loan or line of credit, which sort of goes against the point of paying down your mortgage to begin with.
One other note: we shortened our mortgage to twenty years from thirty years while rates were so low because it only added about $100 to the monthly payment. It seemed like a good financial decision at the time because we were making pretty good money, but then our situation changed and our mortgage payment is now somewhat stifling–we still make OK money, but we’ve locked ourselves into paying too much of it toward our mortgage each month. I wouldn’t do it again–it may be satisfying to know our mortgage is getting paid off quicker, but it’s become more of a day-to-day sacrifice than I’d like. It’s not always about the money, sometimes it has to be about your comfort level as well.
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Jim:
I can’t argue with your point #1, but #2 seems like an odd thing to consider “bad.” Taking money off the back-end seems like a good idea to me. By taking a dollar off the 360th month of the mortgage up front, I’m saving 30 years’ worth of interest on that dollar. Depending on how the mortgage interest is calculated, that could be very significant.
[Assuming a 6% APR compounded continuously for thirty years, we get:
I = P * e^(r*t)I = $1 * e^(0.06*30)I = $6.05]
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Jim writes: “Absolutely not! Do not prepay that mortgage.”
It’s simply not possible to make a blanket statement that applies to everybody. For example, some of your comments don’t apply outside of the USA. Comments below:
“As you prepay in good times, you can’t ask for those prepayments back in bad times or expect favorable treament.”
Actually, I can. My mortgage has enough flexibility to allow me to skip future payments (equal to the amount that I’ve prepaid). Mortgages can vary greatly in their flexibility regarding prepayments and skipped payments.
“The prepayment goes to the backend of the loan. Your $1 pays off the last $1 you’ll pay in the 360th payment.”
Not true. If I pay $1 now, I’m paying off $1 that won’t have interest charged on it for the remainder of the loan.
“no tax benefits.”
I’m in Canada. Mortgage interest isn’t tax-deductible here.
“you are using current money to pay for future payment in 30 years. That is crazy.
Your extra $1000 could be worth $2500 in 30 years. But you get credit for $1000.”
That $1000 you pay now won’t accrue interest for 30 years. Figure out the compound interest on $1000 over 30 years, and you’ll get a lot more than $2500.
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Work hard when you are young – relax as you age, when your body and mind can’t take as much stress. That is…if you think you will live long enough. Dump as much cash on the principal as you can as early in the loan term as possible. For example, I worked overtime to more than double mortgage payments and paid the loan off in 11 years. Now, I have cash to save or invest with no headaches. Imagine the investing you could do with no mortgage. This is one way to get of the “hamster wheel”. I think the interest write-off is a fool’s game. This is not for everyone – but for those with the good fortune of a good income and discipline for self denial, it is a formula that can work for the “working-class” earner.
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[...] and disadvantages to both. But is one choice less wrong than the other? When I covered this subject a year ago, I shared advice from several personal finance books. Here’s what they [...]
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I was actually faced with this situation in a way that it appears most people aren’t. Two years ago, at the absolute apex of the housing bubble, my house which I bought for $125,000 was being valued at $525,000, over quadruple what I paid for it! I wasn’t happy in the city I was lving in, so I crunched the numbers and figured out that I could sell my house and buy a house in another city for around $400,000 that would be much, much nicer than the one I was living in. After broker’s fees and paying off the mortgage, I would walk away with $10,000 in cash and zero mortage at 35 years old.
Lots of people suggested this wasn’t the wisest course, since you can get a better return investing, etc. But the thing was, I was looking at the opportunity to upgrade my life in both lifestyle and in expenses. Now, all I pay is my property tax which is $4,100 a year or around $342 a month.
It allowed my wife to quit her job and for us to start agressively saving on just one salary. I have an emergency fund already set up, but since I have no mortage, my bare bones essential living expenses are around $1500-$2000 a month, so I could survive a loss of income for quite a while.
I know that the math adds up a certain way, but living 100%, no doubt about it, debt-free is a feeling that’s worth money to me.
As much as we lost by going this route?
My answer would be yes.
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Jim you are dead wrong about the tax benefits being one of the reasons why you should keep your mortgage. Tell you what, you give me $10,000 of your money that I will pay towards the interest on my mortgage and I will give you, in cash, the tax benefit I receive from the IRS at the end of the year. I will gladly take the $7k I am guaranteed to earn off of you and run.
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I’ve been reading the invest vs prepay debate for several years and concluded that prepaying is best for our situation as we intend to put more money into our older home in the next 5 years. The list of potential items we’ll have to fix or replace looms large in my mind.
We purchased our modest home 8 years ago. We refinanced twice when the rates were low from 30 years to 15 years to 10 year terms for approximately the same amount of money. I know in 5-10 years or if we have to move that we are going to have to commit some cash to big ticket items that have simply worn out. I want to create the cash flow to do that without debt.
We’ve been pre-paying in bits and pieces, but realized recently we could pay off the mortgage in less than two years without sacrificing our long term financial priorities. We are a childless couple in our early 40′s who have adequate emergency savings, save regularly, max out our retirement funds, and have some smaller investments.
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Great discussion of a really difficult issue. I’ve been struggling with this for the past few years. We purchased a house with 5% down, adjustable 7/1 mortgage without PMI due to my job/stable income. With 2 kids, no credit card debt, student debt consolidated at ~2%, a 403(b) and Roth getting some but not full funding and a 5-6 month emergency fund in place, I want our extra money to go to the “right” place but it’s hard to figure out. Right now it is kind of random – depending on my emotional state each month – the money goes into a mix of savings, extra Roth contributions (if the S&P decline dropped by 300 points), or mortgage principal payments. There is also the issue of vacations – it’s been a while since we splurged but feels hard to do when you barely own a piece of your house and all you hear about is the plunging real estate markete. So, reading GRS has been helpful – at least this is a great dilemna to be in. So, here is my summary of what all of you have been saying. It’s like picking between belgian waffles, french toast or pancakes for Sunday brunch!
To Prepay:
Pyschology – You know that owning your home outright in less than 30 years would be liberating and allow you to enjoy life to the fullest
High mortgage interest rate (7-8% or 3% higher than 1 year CD rates). Would be tough to beat with investing.
You would obsess with your investments “beating” your mortgage interest rate too much. You check your investments more than once per week.
Low equity especially if you pay PMI, a
variable rate “piggyback” loan/HELOC, or have an ARM. Each prepayment gets you closer to lowering your overall monthly payment or the opportunity to refinance on better terms earlier.
You don’t have much total yearly mortgage interest compared to your standard deduction – no tax advantages to paying interest.
You plan to stay in your house for a long time
Your emergency fund is of the 6 month rather than the one month variety and your retirement is being fully funded or at least at a level you feel confident about
Not to Pre-pay
Psychology: the idea of a large chunk of your net worth being illiquid and tied to your home gives you nightmares. You like the idea of having a back up emergency fund that doubles as your “beat my mortgage” investment.
Low mortgage interest rate, no PMI, fixed rate mortgage, more than 20% equity with stable home prices in your area.
You enjoy investing and do so for the long haul. You are pretty sure you can “beat” your interest rate and won’t panic if you don’t during a bad year. You are disciplined and won’t touch this money till your mortgage is paid off.
You already have a lot of equity and will pay off your mortgage in the next few years without extra payments. You have a fixed rate mortgage. No matter what you pay in pricipal, your monthly payment will stay the same till the end of the mortgage.
You are in a high tax bracket with an expensive home. Mortgage interest will be higher than your standard deduction for the next few years or longer.
You’ll probably move soon so you won’t really ever “own” this home.
Your emergency fund is not “fully funded” for your needs, you have kids/illness/lots of fear and anxiety. You aren’t quite funding our your retirement plans fully.
So, Like most things in life, there is never a right answer. Just a more right answer for you based on how many of the “To prepay” or “Not to prepay” factors apply. For me, the main factors are that my mortgage scares me and I would LOVE to own my home before I retire (maybe it would even help me retire earlier), I have little equity and an ARM that I would like to be able to refinance, and we plan to live here for a while. So I plan to throw must of by extra money (80%) into the mortgage until I have ~10% equity. Then I plan to split evenly among mortgage, Roth, and savings/non-retirement investing.
I feel so much better just having a plan – one that is based on the numbers as well as my values and goals!
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We just paid off our house and my wife and I feel like we are in utopia. I heard all the arguments about putting the money towards retirement, the tax savings, etc. But at the end of the day we simply invested 20% of our income into retirement and put the rest towards the house. It really hit home what kind of freedom we will experience when there was NO payment at month end. We literally had an extra $1800 to spend on anything we want. You don’t realize the burden you repress each month until the house is paid for…it’s like so many things you just “deal with it” but once its gone you really feel free.
Like so many posters on this site how we got our home paid for was real simple. We spent less then what we earned and paid cash for those needful things at the register. We bought 3 year old medium mileage cars. We did not vacation in Hawaii, Disneyworld, or Europe. At first our friends called us frugal or misers but now we have the same “stuff” they do but it’s all ours, while they have car and house payments to deal with for years. Now this summer we are going on a nice trip while the miser callers need to stay home, their equity lines need to be paid for and the times are a bit lean.
So my advice is to pay ALL debt now and simply cut-up the credit card. (When my wife and I first got married I pulled her credit cards out of her purse and froze them in a bowl of water in the freezer. That way, if something was that important to buy, the effort would need to go towards the defrosting of the card FIRST…funny how often that need went away on leaving the store.) Debt should NOT be a burden for life simply a vehicle to your home purchase. Those financial advisors who say otherwise, don’t get commissions on early debt retirement, so their advice is suspect!
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This strategy does indeed provide a return equal to the difference between the mortgage cost and market returns. However, the average return will have the variance (risk) of the stock market returns. If you’re looking for a 2% or 3% return with the risk of the stock market, this is the way to go. But, you can earn 3% from money market funds with only 3% standard deviation.
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Follow-up to earlier posting on July 25th, 2008: My income dropped 40% this year but we are fine because our home is paid for. Had we followed the advice of “experts” our cash flow would be tight or negative during some months. Our emergency savings remain untouched and we have managed to invest this month into the market.
Again, pay-off your house, you can’t assume your income will remain stable and the so-called experts have their own agenda.
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After you contribute to your 401(k) to the point of any company match, you can’t really lose by using any extra money to prepay your mortgage — especially in a secular bear market that may be around for years. For a detailed analysis on this please check out:
http://lenpenzo.com/blog/id477-paying-off-your-mortgage-is-a-no-brainer.html
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Hi, I am thinking about prepaying my mortgage. I have already maxed my 401K with my company. I have a 30 year fixed loan at 4.87%. My loan balance at the moment is about 195K. I have put down 20% down payment when I purchased the house this year. House valued at 245K. I have a nice emergency cushion for at least 6 months. I have no debt at all. I am lucky to still have a job as well as my wife. If one of us is laid off, we can still make the payments and save without using the emergency fund. Our mortgage is about $1000(principal and interest).
Should I prepay the extra $500 towards the mortgage to pay it off in 15 years or invest? Please advise.
Thanks for all your advice
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Michael,
I’ve posted on this board and my recommendation remains the same. If at all possible pay down your mortgage. In your case, I don’t see much point in lowering the amortization period due to the great rate you have. I would simply toss an extra principal payment whenever you can.
Overall, I would dump even more then $500 into the loan right now if you can. Since early high principal payments, which taper off into the future, are far better than a flat amount on an ongoing basis.
In my family’s case, we bought our home in 2003 and owed 180k. Instead of dumping money into an over the top yard, pool, or remodel we focused on retirement and the mortgage. In 2008, thanks to principal payments, the home was paid for.
Of course the financial experts said I was a fool. The rate I had was quite good while the market paid far better. It was not foresight the market was going to drop (else I would have shorted all my holdings and be fully retired now) but knowing I was betting on a SURE thing. That is, the market goes up and down while you can know for certain your amortization schedule.
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Here is my situation:
We bought our home 100% financed in March 2007 with two mortgages (hadn’t sold former home yet so really 3 mortgages, but had to jump or miss it as we had the other 3 chances at a 4 bedroom within the zone we were shopping – usually sold in 10 days or less in January 2007). The mortgage on our previous home was paid about 6 months in advance so I didn’t actually have to come up with 3 monthly payments to do it, just the first and second on the new house.
We sold the previous home within 2 weeks and took almost all the proceeds and paid off 100% of second loan and about another $10,000-$12,000 on first mortgage, but I used it to make about 8 monthly payments in advance for a safety net. I am self-employed over the last 8+ years and my wife works part-time for the fairly recession proof school district. We have about 6 months in cash.
My first mortgage rate is 5.625% on a 30 fixed a payment of $1015.00 monthly (currently about $333.00 of that is going to principal). My loan balance is about $146,000.00 now on a $241,000.00 house and we are also funding the kids college educations via a state pre-paid tuition plan. I am currently putting $1500.00 monthly to the college plan (twins are in the third grade, I also have a 5th grader with 4 years already funded). I will be done funding the tuition plans at 4 years each in summer 2010. We also fund 3 Coverdells to the tune of $6,000.00 yearly and full IRAs for both of us (another $10,000.00).
My second mortgage was a 30 year fixed at 7.935% for $58,500.00 It was paid off without penalty in the second month (saving $176,000.00 in interest).
We have no debt other than the home thanks to the debt reduction gurus because we were swimming in about $50,000.00-$60,000.00 of card debt until 2006 which we took on for my wife to stay home with the kids for first few years, we considered the interest our “Day care cost”. We purchased two used cars since 2007 (1-2 years old each) and knocked out the note in less than 1 year in both cases.
I am currently paying 2200 monthly to the mortgage (1 regular payment and additional to principal), so just over double the required payment and I am still 1 year ahead on required payments, so I could stop paying for a year and be fine.
My plan is to increase mortgage payments to 3000 for one year after paying off the college plans (increasing household cashflow by about 400-500 per month vs. we pay now between the two expenses). I will then pull it back to 2300 a month (increasing household cashflow another 700 monthly) and finish the mortgage in just over 5 years from today if my calculations are correct.
I figure I will save about an additional 20,000.00 in interest for each year I follow this plan from here forward (so roughly another $100,000.00). In less than the first 3 years of the loan I calculate that I already banked about $242,000.00 in interest and future interest ($176,00.00 in interest not paid on the second mortgage and about $66,000.00 so far on the first due to pre-payments) and I would have taken a huge hit on the money had I put it in the market instead.
My calculations were that in the first year of the loan, every $100.00 extra principal knocked an entire payment off the end and all the interest in between (or $168.75 interest saved per $100.00 extra paid in addition to taking it off the principal owed). My calculations are that for every 3.5 payments I make the way I am paying them right now I knock another full year off the end of the loan.
If I stopped all pre-payments right now, we would still have saved over $242,000.00 in interest and would complete the loan about 9-10 years early. I would also still have a 1 year safety net in pre-paid regular payments.
We are in a blessed position with regard to income right now and I want to make the best decisions I can while times are good in case they are not later. I would like to be mortgage free before my first leaves for college and be able to pay cash out of pocket the finances they will need beyond tuition and fees (if any, given the Coverdell funds that will also be available). Depending on where they go and our cash position, I might just buy condos in cash for them to live in during college and then either rent them (in a college town) or sell them off after that depending on market conditions, we’ll see…..
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