Mortgage Prepayment Made Easy: Own Your Home in Half the Time
Published on - February 12th, 2008 (Modified on - March 8th, 2012) (by J.D. Roth) Because I recently eliminated all of my non-mortgage debt, I have a significant positive cash flow. The $1,000 per month I was putting toward debt can now be used for investing. I’m making maximum contributions to my Roth IRA, of course, but that still leaves several hundred dollars each month available for other purposes. This has forced me to evaluate my financial goals.
Mortgage prepayment options
For the past year, Kris and I have discussed making accelerated payments on our mortgage. I’ve written about this choice several times at Get Rich Slowly, and it seems clear that mathematically it makes more sense to invest the money. However, it’s also clear that eliminating a mortgage offers a tremendous psychological boost. I’ve never heard anyone say they regret owning their home outright.
I’ve researched a variety of mortgage acceleration schemes:
- Refinancing from a 30-year to a 15-year mortgage is appealing, but the interest rate drop (from 6.25%) isn’t enough to make this worthwhile.
- I could sign up for my bank’s bi-weekly payment program, but I don’t like the enrollment fee, and I don’t like the increase in paperwork.
- We could make an extra payment every year, or pay an extra $100 per month. But I feel like we could do more.
Ultimately, we decided to use the method described by Charles Givens in his 1988 best-seller Wealth Without Risk:
You can pay off your 30-year mortgage in half the time without refinancing by making extra principal payments. On the first of the month when you write your regular mortgage check, write a second check for the “principal only” portion of the next month’s payment.
You can also use a prepayment calculator to figure out additional scenarios.
[Article Continued Below..]
Wealth without risk
For most of homeowners, the principal portion of a mortgage payment is quite small. For example, our February mortgage bill was $1681.79. Of this, $1119.16 was designated for interest, $295.19 for escrow (taxes and insurance), but only $267.44 for principal.
Using Givens’ plan, if I include an extra $267.44 with my payment, I’ll also knock off the next month’s payment from my mortgage. That $267.44 accomplishes the same thing $1681.79 usually does, but at 16% of the normal monthly cost. That’s a bargain.
The advantages this method are:
- It has a sliding degree of difficulty. At first, the extra principal payments are lower. But as we pay down the mortgage, these extra payments increase. We have time to “grow into” these increased payments.
- It’s easy for us to back out. If we decide our money is better used elsewhere, we can simply stop making extra principal payments.
- Every time we make a payment, we’re essentially making two payments, cutting the term of our mortgage in half.
After discussing the pros and cons, Kris and I have agreed to follow a modified version of Givens’ plan. To make things simple, we’re using round numbers. During 2008, for example, we’re going to pay $2,000 toward our mortgage each month, which gives us an additional $318.21 against the principal.
Every January, we’ll adjust how much extra we’re paying. If our budget gets too tight, we can cut back at any time.
The drawbacks
To be fair, Givens doesn’t recommend this method for low-interest mortgages like ours. He clearly states, “Never pay off low interest mortgages — those under 9%. Instead, use the extra money in a better investment.” He wouldn’t advocate using this method on a 6.25% mortgage.
The March 2008 issue of Consumer Reports has a brief exploration of this topic. Their conclusion?
Many people find peace of mind in paying off their mortgages and owning their homes outright, especially as they approach retirement. That can make an investment in your mortgage a worthy choice, psychologically if not financially.
Still, the bottom line, according to our Money Lab, is this: Although there are exceptions, chances are you’ll be better off putting extra money into a good mutual fund, not into prepaying your mortgage.
“Did you see this article?” Kris asked me, after she finished reading it.
“Yes,” I said. “What do you think?”
“I don’t care” she said. “I want to do both. I want to invest and prepay the mortgage.”
“So do I,” I said.
Financial freedom
If we have a substantial emergency fund, if we’re fully-funding our retirement plans, and if we’re saving for other goals, I believe that paying down the mortgage makes sense for us. We understand that we’re sacrificing some theoretical (and probable) future investment returns, but we’re also working to create a financial situation that’s easier for us to maintain in the long run.
If we have no mortgage, that’s $1400 less each month that we have to pay in expenses (we’ll still need to pay taxes and insurance). Since we split the payment, that’s $700 less per month that I have to pay. Without a mortgage, my fixed expenses would be about $600/month. My total expenses would be about $950/month. This would provide tremendous freedom, granting me an opportunity to try things that I might not otherwise be able to do.
Another form of diversification
Every investment book I’ve read says that a smart investor diversifies his portfolio, putting some of his money into each of several different types of investments. I view prepaying the mortgage as diversification. Sure, the stock market will probably beat the 6.25% I’ll earn by doing this, but it’s guaranteed money. To me, it’s better to put my money into my mortgage than into bonds, certificate of deposit or a high-yield savings account. Especially if we’re entering a recession.
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I can understand the psychological pull of having the mortgage paid off. I have an unusual mortgage, it is interest free. I imagine everyone would say do not pay off ahead of time. I know that in my head. But every month I make the payment I still think how great it would be to have that cash in my pocket. So I have to constantly remind myself that the head is right here even though in my gut I just want that darn payment gone!
I did for years use the extra payment each month strictly for the principal when I had auto or other loans. It sure did make the loan melt away, but the banks did not like it, they always wanted me to apply the extra to the interest. I admit I never did understand that.
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b-bo wrote: I feel like with your transitioning to full time blogger, some of the recent posts have been a little fluff heavy. This is a good, thought provoking post.
Thanks. I, too, feel like some of the recent posts have been fluff-heavy. And it’s precisely because right now I don’t have the time to spend on the site that I want. While I’m training my replacement at the day job, I have less time to spend on GRS, and I find myself “out of the groove” with writing. (In order to stay sharp, I feel like I have to write nearly constantly.) Currently, I’m writing mostly on Tuesdays and Sundays, trying to get everything done for the week. It’s not working very well.
The good news, though, is that there’s light at the end of the tunnel. As soon as the new salesman is trained, I’ll have lots of time for writing.
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We did this (paid off the house in 7 years) and I wish i’d not done it. i had a 5% interest rate and would have been much better off putting the money in to Roth IRA or something… we not get basically NO tax deductions, at least before we could write off the interest
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Barring major unexpected expenses, my wife and I will pay off our mortgage this year. I bought the house in 2002.
While theoretically we would be better off investing the money, it’s pure theory. I subscribed to that theory in the late 1990s and I lost half my savings in the aftermath of the dot-com bust and 9/11. If I had put even half of the money into my house, we would own it now.
The return on investment paying off a mortgage is guaranteed.
Additionally, you can’t put a price on the freedom. Have you ever lost your job? I lost my job twice in one year, due to working for employers who were having financial problems. (One of them has too much debt–its operating profits for the year barely cover the interest on its debt.) At the time I didn’t own my car or the house. That was $1,500 worth of payments I had to make every single month. Without those payments, I could have gone without work for months while I waited for the right opportunity. As it was, I had to take whatever job was available. So I ended up taking a job initially with a company that was in trouble and I was back on the market four months later when they did a mass layoff of people who met certain criteria (and I was one of them). I knew that was a risk going in. Then I waited two months for another opportunity, and the only thing available was a 45-minute drive from home. Did I want it? No. Did I have a choice? NO!
Or let’s say I’m sick of my career field and want to change. If I own my house and my car, I can afford to take an entry-level job and do that. I can probably even afford to go back to school if that’s what’s necessary. Or I can afford to start my own business even if it only looks like I could make $1,500 a month on it initially.
I don’t care what the interest rate is or what inflation is doing, as long as you’re on the hook for $1,000 worth of payments to somebody–anybody—every month, somebody else owns you.
That’s OK if your job is secure, but I know very few people whose jobs are truly secure anymore.
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Thanks for this post; I am still a renter, but reading articles like this one will help guide me when I’m finally in the house-buying stage.
When I do buy a house, I think I will pay off my mortgage quickly as well, simply for the peace of mind and not having to work because of debt. BUT of course I would want to make sure that my IRA and 401k are still being funded, and that I’m also putting money into liquid savings. That way I’ll still have cash on hand and my retirement secure, and not have everything locked away in a house.
Oh and JD even though you think you haven’t been writing as well, I still appreciate your blog! I mean, you write something new everyday, and you don’t see that in every blog.
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@KC: The taxes and insurance are not paid out of the money you borrow, but out of an escrow account that you pay into. Basically, the lending institution sets up a savings account (and some even offer interest on the money you deposit) that you paying into monthly on your mortgage payment. They then, in turn, pay your taxes and insurance from that account. You do not pay interest on your taxes or insurance payments, however.
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Skimmed through the comments and didn’t see anything addressing this – but instead of saving $1700 a month when your mortgage is paid, you really are only saving about $1400 – you’re still going to have to pay homeowners insurance and property taxes. Still a savings, but worth noting. Sounds like that will up your fixed expenses from $400 to $550 a month.
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@KC: You’re not paying interest on the escrow part of a loan. In fact, you actually get paid a little interest on your escrow balance. Think of it as a free budgeting tool. One way or another, you are going to have to pay the taxes and insurance each year. If you don’t have an escrow account, then you must be disciplined enough to look at your taxes and insurance and set aside enough in your budget to cover those payments. With an escrow account, they do that planning for you and tell you that your monthly payment is $x for principal & interest, plus $y for taxes & insurance. On our house, current taxes are approx $4300/year (all numbers rounded for simplicity) and insurance is another $800. We pay an extra $425 each month as our escrow payment. The extra amount is for a small amount of cushion. If the overage gets too large (because of declining taxes maybe (yea, right!)), they’ll issue a refund check and change our payments. If the costs go up, they’ll notify us and our payments will increase.
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You could put the tax and insurance in a savings account. That way you are earning interest on the money for the year not the mortgage company.
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a few things to think about:
1) your mortgage payments are typically fixed in size and front loaded in interest. suppose you have a 100 month mortgage, and you prepay enough to drop off the LAST 10 months. the money you save is the interest on THOSE LAST PAYMENTS. since the payments were front-loaded in interest, you aren’t saving as much in interest as you might think. (ie – you pay a lot of the interest up front)
2) though the money saved in prepaying a mortgage may appear inferior to investing in, say, an index fund, there are a lot of extra returns you get on the mortgage. for example, if you pay to live in a good school district, then your kids go to a better high school, which may get them into a better college, etc. this is implicitly included in the mortgage payment, but is not reflected in your savings for prepaying the mortgage. this may apply more to picking up a mortgage in a more expensive neighborhood more than prepaying the mortgage, but i think the ideas are similar.
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d^2, that’s why a great calculator is needed for such computation. One shouldn’t guess in these scenarios that can be easily calculated.
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What do you think about using that extra money to invest in another property that could be rented? You’d then have two properties, and be paying the mortgage for only one. You could then eventually sell the rental property and use the equity to pay off the mortgage balance on your home or put toward retirement or other investments.
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Thats what my Wife and I are doing, we actually did things the opposite way around. We (instead of buying a house to live in) bought investment properties first, then bought our”dream” home using equity from a property as the deposit. Thanks to this site I am now paying as much as I can into the mortgage offset account to free ourselves of debt asap (interest only offset just in case we ever turn it into an investment property we can then remove all our money and it would then be 100% tax deductible on the total debt). Once our mortgage is paid out, we can rest easy and the investment properties will provide a reasonable income into the future (A little less than we both earn working full tme now but we only plan on using the minimum for the first few year). Alhough we will most probably purchase some more as time goes on at a rate that keeps our time free of compulsory work.
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If anyone is thinking of doing the bi-monthly payments, make sure you read the fine print. I tried it with my former mortgage company (WaMu) only to find out that they were just holding my first payment until the second one came in and making one payment at the end of the month on my mortgage. And they wanted to charge me a fee to do it! I obviously canceled it immediately. Grrr!
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Two comments:
1 – A 20 year mortgage is a good compromise if you can refinace to a lower rate, but don’t want to commit to the 15 year. There is a pretty big difference in payment between 15 and 20 year mortgages.
2 – One benefit of not going all out to pay off the mortgage that I haven’t seen mentioned is that you need to learn to invest. Ideally, most of us will have $1-2 million or so when we retire to live on. We need to know how to invest that and make it last. What are you going to do when you see $100,000 disappear over a couple of weeks because the stock market gets a jitter? A loss is be easier to handle when it is $1000 or $100. You need to be investing smaller amounts now (dealing with ups and downs, other investments doing much better, lots of noise about what you should be doing, etc). Also after 10 years of this you will have a much better idea if it is a good idea to pay off your house early or not. Your investments will have a track record. If you put all your efforts into paying off the house, you will be putting off learning (hands on, with your own experience) to invest until your house is paid off. It seems to me that it would be best to take your $500-1000 and continuously invest it for the next 10-15 or so and use it to learn how to invest small sums and the patience to have it grow over time (unfortunately not without dips). If you put the $1000 to paying off your mortgage, maybe you get it paid in 8 years or so, but then you need to invest $2300 or so every month. This requires a bit more guts than $700, but if invest along the way when the house is paid off, you will have experience with investing $700 a month and more confidence. And like someone else said you’ll have savings in your investments that you can use to pay towards the mortgage earlier if that is what you want (if you prove to yourself that your long term investment gain is indeed below the mortgage rate).
Anyhow, I know you weren’t planning on paying the mortgage off as the absolute highest priority, but I hadn’t seen learning to invest given as something to consider. A lot of people cut back on their 401k contributions in 2002 and didn’t restart them until recently. It takes some guts to ride out the hard times and the more money at stake the worse it is. You can read a lot about investing, but you need to experience it with real money. You need to invest enough to eventually learn how to deal with large amounts or your not going to meet you goal to get rich slowly.
Bryce
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Hi,
This comment does not really fit with the above post, but I keep reading your blog and wondering if you can help.
My husband and I recently purchased Total Money Makeover. We want to live by the Makeover rules, but we are having a difficult time even getting our budget to work. In order to save $1000 towards our emergency fund or to even start working towards paying more towards our mortgage, we need our monthly budget to be out of the negative. Is there any way that I could email you our budget and you could help us evaluate it or you could post it on your blog and have others tear it apart? We are wondering how much of the difficulty comes in being “used to” spending money in such certain ways that we can’t see a way towards change. Or maybe, we just are going to have to slide by until my husband gets another job. My working is not an option right now, because I have four-year old triplets and a baby on the way.
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It’s better to stash the money in an account and pay off the mortgage in one payment. That way you have the cash in hand and it’s more security job wise (running this blog).
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This is interesting however the way I think of it is:
1) the more money I put on the principle the more money I don’t earn interest on
2) the less interest I pay – the less I get to write off on my taxes (another great bonus)
3) the more money invested in the house – the less liquid I am – this is the reason the mortgage companies are hurting (I’d rather earn appreciation on the value of the house with someone else’s money)
4) Personally I’d rather see my personal savings grow – with interest and everything and then if I’m feeling like owning my house outright I can pay it off in one lump.
Anyhow – these are my thoughts… your mileage may vary.
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Let me provide a Canadian spin on the issue:
Mortgage interest is not tax-deductible in Canada. However, any appreciation on one’s primary residence is not taxed. Otherwise, outside of an RRSP, interest is taxed at the marginal rate for income, while capital gains are taxed at half that rate.
That means that on a 5.25% mortgage, any prepayment results in a NET gain of 5.25% at virtually no risk. A high-yield savings account of GIC (both of which are interest-bearing and thus taxed at the highest marginal rate) for a taxpayer with a federal & provincial combined marginal rate of 46% (the highest rate in Canada) would have to get a return of 8.2%(!!!) to get the same risk-free return.
Now let’s assume the money gets invested in stocks instead, where capital gains would be taxed at 23% in the same bracket. The stocks would have to return 6.7% to get the same result. While this is achievable, it is tied to a significant amount of risk. Stocks do not always go up.
So let’s say with a balanced mutual fund one could get a return of 8 percent over the long run, which is very realistic. Would you trade one additional percent of growth (after taxes) for the risk of stocks?
The situation may be different in the U.S., but up here, prepayment is a very good idea.
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Another way of looking at this is that paying off the principal is an additional hedge against the risk of losing your job or otherwise finding yourself in a position of not having monthly cash flow to pay off the mortgage.
Said another way, if you lose your job in 15 years and have paid off the mortgage, you have a lower balance in your retirement accounts but someplace to live. Had you put that in a retirement account, if you lose your job in 15 years you could wind up having to cash in your retirement if the emergency fund runs out.
Effectively, by prepaying, you are making a bet that at some point over the next 15-30 years, you may hit a financial rough patch.
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[...] Pre-Payment [Link] Jump to Comments J.D. Roth over at the Get Rich Slowly finance blog made a good post today regarding pre-paying on a [...]
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@John, But, you can’t refinance your home if you don’t have a job. So if you lose your job and run out of cash from your emergency fund, where does the money come from?
Someone explain why banks loan you the money if they can get 8% from the stock market? If it’s such a safe bet, then why can’t I get a loan to buy part of an index fund? If it’s so easy to get 8%, then why would a bank give me a loan for only 6%?
It seems to me, that you get very good deals on taxes if you invest in your retirement. So I’d pay that before or at the same time as the house, but if banks are making billions making safe bets on mortgages (present months excluded) then why wouldn’t I want that same return?
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My husband and I went with a similar plan, we are paying extra principal each month which basically cuts the term of our mortgage (26 years left on a 30 year mort.) in half. We are still thinking about a refi but we also like the flexibility of this plan.
We made the first extra payment to Wachovia last month. I’ve noticed that this month my regular mortgage payment which is normally allocated and applied on the 8th has been stuck in a suspense account since 2/8. I’ve already called Wachoiva once and they said the normal mortgage payment would be promptly allocated/applied to principal and interest but its still sitting in the suspense acct. I’m going to call Wachovia again tommorow if the payment is still not properly pplied. I wonder if paying extra principal triggers extra holding of the normal mortgage payment so the bank can collect extra interest… growl and frown.
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Great information. If every homeowner put this plan in place the day after they closed on there home. Then we can beat the banks at their own game. And foreclosures would be at a market low instead of a market high.
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@Tana
“We’ve paid off about 5% of the loan in the 5 years we’ve lived here. In the next 5 years of living here, we would pay off more because we would be working on the 2nd 5 years of the loan, and it would snowball from there. But if you buy a different house every 5 years and pay the current price of real estate at that time, you can be retiring and still owe big money on your house.”
This is only true if you take out a 30-year mortgage every time you move. If you do that, then it’s effectively the same as staying in the same house but refinancing to a new 30-year mortgage every five years. In both cases you never pay off the mortgage because you’re always stuck in the first five years.
What you should do is treat your new mortgage like a continuation of your old one. If you’ve paid off five years of a 30 year mortgage when you move, then you should only take out a 25 year mortgage on the new house, and if you move again five years after that only take out a 20 year mortgage, etc. Or even shorter if you’re making extra payments.
Obviously, this is impossible if you’re moving to a much more expensive area. More money is more money, so you either have to take a longer term or pay more each month, and the latter may be flat out impossible. But otherwise the way to avoid the permanent mortgage is to avoid lengthening the term, even when you move.
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Dave C was quick on the draw to start the United First Financial bashing. United First Financial is a viable option for paying down your mortgage faster regardless of what you read about it on some of the forums around the internet. It’s easy for folks to hide behind the anonymity the internet provides and bash a product they don’t understand, have no experience with, and/or are threatened by. The United First program works but isn’t for everybody. Can you pre-pay your mortgage on your own without United First’s program? Absolutely. But can you do it with the same accuracy that the United First program can while maximizing savings over the time period required to pay off your home? I don’t think so. If you want more information on United First Financial get in touch with a certified agent to get the latest, most accurate, information.
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My house is just the place where I live. The interest, taxes, insurance, and PMI is slightly less than it would be to rent, thus I bought a house. I get the added bonus of a moderate tax benefit (just barely exceed the standard deduction) and potential price appreciation. People who keep talking about paying off their mortgage seem to be more in love with their house and the idea of having it paid off than anything else. If that’s where your priorities lie that’s fine with me, but you won’t ever catch me paying off my house until I find a place I want to own for longer than the 15 year loan term. My investments (stocks, bonds, REITS, etc) are what will build wealth.
Another way to frame this decision is this: making accelerated payments on your mortgage is in a round about way equivalent to investing in bonds. You are effectively getting a bond yield where the primary risks are inflation, interest rates, and default. Paying off a mortgage on your home is NOT an investment in real estate but rather an investment in a BOND issued to yourself. You default on your mortgage (lose job, natural disaster, etc) you will be defaulting on the bond and loose your early payments. Thus, you are probably throwing your asset allocation out of whack from its ideal. This analogy may not sink in for everyone but you must realize that you are shifting risk from the lender to yourself rather than decreasing it all the way until the last payment has been made and you have the deed in hand.
I strongly recommend everyone keep their mortgage, invest, and when you find the house you want to die in buy it cash. Feel free to shoot me an email (adfecto (at) aspire2wealth.net) if you need more clarification.
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Another issue is liquidity of money. If you prepay the mortgage, you are increasing your equity in the house, but that money isn’t really easily accessible. Whereas an investment in a mutual fund is much more liquid.
One other commenter mentioned that it might be only 1% difference in return (in Canada), but over the course of 30 years, a 1% difference (say between 6% and 7%) is actually fairly large. You would have about 40% more money with the 7% gain than with the 6% gain. I think the difference would be a little bit higher in the US due to the mortgage interest deduction. And again, you really don’t see the big benefits (i.e. owning your house and eliminating the mortgage payment) for 15 to 25 years.
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We are slowly paying down our mortgage. When I refinanced in 2003, we went from a 30 to 20 year loan. I saved $64,000. I asked the man what made the difference, and he said that it was the time, not the rate which counted the most. So, we send money in every now & then as we can. We don’t have to, and I used JD’s “throw chunks of money at the mortgage every now & then” excel thingy and basically for every dollar we send in, we save a dollar. (thanks for the spreadsheet, JD!) Our mortgage is not huge, because we bought a small house. We plan to pay it off in time for the kids to start college. That way we have a bit more flexibility when we need it.
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I haven’t had time to read all the comments, but two things came to mind when I read your post: you mentioned you are maximizing your ROTH IRA, so I am assuming you are contributing $875 per month ($5000 divided by 12). My question is why don’t you contribute the extra cash flow into your ROTH now, and let the compounding do its magic? I maximized my ROTH IRA on Jan. 2 rather than spread it out.
My other comment is that I chose not to have my property tax and home insurance taken out each month. I take what I would have paid, put them in high interest yielding money market account (Vanguard Prime Money Market Account), and keep the interest the money earns.
Really, really enjoy reading your posts. Keep up the good work.
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I know this is super old. But $5,000 divided by 12 is $416.66…
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[i]Refinancing from a 30-year to a 15-year mortgage is appealing, but the interest rate drop (from 6.25%) isn’t enough to make this worthwhile.[/i]
I strongly disagree with this.
There are lenders out there that will refi for total closing costs = $200 plus title insurance plus interest (you pay the interest anyway).
A couple weeks ago you could have had a 15 yr. mortgage for 4.625%. That’s a 1.625% savings, and is huge! For a paltry up front cost of $1000 /-.
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Liquidity does depend on where your money is, but if your money is in a pretax plan or in an IRA, you may be subject to withdrawal penalties.
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I think it’s great that you are carefully considering the best way to pay off your mortgage quickly- it is diversification and the rate of return on a CD is only about 5% so it makes sense for a guaranteed investment. Liquidity is the only potential problem, but your other investments and emergency fund should cover that.
>Refinancing from a 30-year to a 15-year >mortgage is appealing, but the interest rate
>drop (from 6.25%) isn’t enough to make this >worthwhile.
That really surprised me as I just refinanced and found it would help out significantly in both time and interest payments. I went to http://www.banksite.com/calc/prepay and did some calculations to see how it turned out… unless I’ve made a mistake it seems that a refinance would be mathematically better than just repaying.
From the numbers your article I estimate your current principle is 214664.
If you refinanced to a 5%/15 year mortgage you would have to pay an additional $310.95 month. You would also need to come up with the closing costs, I estimated $4000 in non-refundable closing costs, which is likely a bit high. Escrow should be a wash but you would also need a few thousand to fund the new mortgage’s escrow until you get the money back from your old escrow account.
So assuming that you DON’T refinance but put a lump sum of $4000 down and made an additional payment of 310.95/month on your current loan the calculator predicts 201 months (16.75 years) to fully repay. The extra 1.75 years of payments add us to about 35,000!
Of course if you refinance you won’t have an option to NOT make the extra payment, so that is a consideration. The other risk is that if you move within a few years the closing costs will be a loss.
-Rick
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I haven’t read all the comments, but of the many I have read no one also mentions that the mortgage interest not paid by paying the mortgage off early in reality is a gain. That gain is not taxed as income.
So if you are in the 25% tax bracket that investment you choose instead of paying off early needs to beat an approximately guaranteed rate of 7.75%. Nearly 8% guaranteed is a HUGE return!
The S&P 500 over the last 10 years has earned what. 6% /-?
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I am an old fart… here is my story:
My first house I made the monthly mortgage payment (principle and interest), then I added FOUR principle payments. The loan was for 25 years. As time went by I could not afford four principle payments and had to cut back to three. I ended up paying off the mortgage in about 7 years.
Because I did not have a mortgage I was able to purchase a vacation home on Cape Cod, MA. I am living in that house now having sold the first house. I have remortgaged this house twice and have it almost paid – owe about 30K. This house went up in value about 475% since I purchased it (21 years).
I consider it a good investment. I could pay off the mortgage at anytime, but no need to now. I was very happy and contented when I paid my first mortgage off and never regretted it.
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Careful: paying off your mortgage is not really diversifying. Diversification is about spreading your investments across many assets. By owning your house, you are very likely investing a large % of your money in only one asset – your house.
Also, paying off your mortgage is not really a guaranteed return (as others have pointed out here). Contrary to public opinion, housing prices can and do fall (stay tuned in the US economy to see just how far they can fall.) If you pay extra principal off on your mortgage and your house falls in value by the amount of the principal repayment, you have just lost 100% of your money.
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I did put it in perspective by using actual calculation. To make a sound decision, this query needs to be calculated as oppose to speculate.
My example above with only additional $250 dollar monthly payment on 200k loan is saving upwards of 70k in interest alone.
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@k – head over to the forums and post your budget there. There are so many people who are willing to help.
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This month’s Kiplinger magazine had an article about prepaying mortgages.It talks about the cost of ownership/upkeep–typically between 1-3% plus interest when considering prepaying versus investing. I tend to think of my home as less of an investment asset and more as simply shelter that will require money to maintain. I will always need shelter. Appreciation on a well maintained house will be a bonus if we need to sell. We are chosing to prepay and invest too. It feels right. Our house will be paid off in 19 months. Time will tell if we have made the right choice. Obviously we really like our house. Bank of America was offering a no fee refi for a while–we happily switched to both a shorter term, lower interest mortgage two years ago.
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I use something called Offset Account (in Australia). This account allows to redraw and incurs low fee. Both our salaries come into this account and interest is calculated on daily basis and credited monthly. So with a combination of 60 interest-free days credit card and minimum withdrawals from this account, I see that the interest portion I pay monthly is considerably low and I am hoping to pay off the mortgage in 10-12 years.
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Maybe you have talked about this before, but what is your reasoning for why you “split the payment”?
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Hello, my first time here. Great topic. I invest in real estate part time (among other things) and am a firm believer that real estate is the best investment. To me, the stock market is like flying blind, though I admit I haven’t studied it as much as others.
I know the real estate market is “down” but investing is still sound when using sound investing techniques. Those who simply want to buy low and sell high don’t truly learn the profession.
As I see it, if we’re talking about simply investing in stocks, bonds, etc. to save and earn interest and then make a lump sum to pay off your mortgage is not reasonable. Like mentioned above, the safe investment in paying down your mortgage and saving on the interest is a better value-to-risk option (again, for me that is).
If you want to invest in something that will pay down your mortgage, then you should invest in . . . mortgages (again, there’s more to investing in real estate than buying low and selling high).
If you sell your house or invest in a property, consider selling it and taking back a 2nd mortgage (if the buyer has decent credit).
Let’s say the 2nd mortgage you are holding for them is $50k with an APR of 9% and payments of $450/month. Now you’re not only earning 9% on your money (much more than 6.25%) but best of all, you have $450 to use to pay toward your principle!
What happens if they don’t pay you? Foreclose. What happens if the bank with the first forecloses? You buy it. Why not? You own $50k in equity.
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The 6.25% interest rate on the loan is actually 72% of that. Since you get to deduct the interest expense; the interest rate paid needs to be reduced by your tax rate. So, let’s say you are in the 28% tax bracket; the real interest rate on the mortgage is 4.5%. There are many places that you can receive better than a 4.5% return on your money for little or no risk.
The money put towards the payoff can yield no more than the 4.5%, whereas other investments have substantial upside potential. I’m making payments on schedule, maximizing all possible tax deferment options (ROTH, IRA, 401K, 403B, and others), and investing the rest in a diversified mix.
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I didn’t see this mentioned: PLEASE remember to mark ON THE CHECK the amount of money you want applied to extra principal. If you do not, you could end up prepaying your mortgage INTEREST. My sister did this for a while, and didn’t mark the principal since she was paying online. Her money was misapplied and it was a headache to get it fixed, and her bank refused to backdate the correction, meaning that she didn’t get the savings she planned.
Read the fine print, talk to your bank ahead of time, and write it on the check!!!
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@k- if you want, i’d be happy to take a look at your budget and offer some suggestions…my wife and I have been volunteer budget counselors for ~6yrs+ with Crown, but we use lots of Dave Ramsey material in our counseling, so am very familiar with and recommend his approach.
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bi-weekly mortgage payments explained:
I scanned the comments and didn’t see this, so if I missed it, pardon the duplication.
-Most banks charge a fee either by pmt or a setup fee or both, amounting to several hundred $’s, all the while touting the Thousands you will save.
-while the $avings is real, it’s a complete scam to pay for it and 100% profit for the bank/lending institution and here’s why.
-How it works…Paying bi-weekly means you make 26 payments per yr, dividing by two means 13 ‘complete’ payments vs. the 12 you would make with monthly payments, thats it.
So, you make 1 extra month of payment per year on a bi-weekly plan, which does amount to thousands saved over life of the loan, but nothing you can do yourself with a little discipline.
BTW JD, I highly recommend the approach you’re taking of paying next months principal this month. It’s easy, it’s a gradual increase over time as your income increases, and it works.
When comparing investment return vs. guaranteed return on paying down mortgage, don’t forget to include inflation as well as taxes. So if you get 12% investing and subtract 5% for taxes and inflation you get 7%, not a whole lot better than 6% on a mortgage, so seems less appealing to me.
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Here’s my thoughts in numbers:
Tax Savings
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Standard Deduction (Married filling jointly): $10,700
Interest for $150K home @ 6% 1st Year: $8949.87
So tax savings for having a mortgage = $0
Return on Investment
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Using 8% as standard return
8% * 70% (subtract the 30% for taxes) = 5.6% return
And if you like to trade stocks, subtract 30% for taxes, another 15% for capital gains: 8% * 55% = 4.4% return
So using our previous example, 6% > 5.6% > 4.4%. Paying off home makes more sense.
Return on Real Estate
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If you did not purchase a home in one of the “bubbles”, you can more than likely expect a return on real estate at least that of inflation (runs between 2% – 3%), so the $150,000 home returns between $3K – $4.5K in the first year. And although every one mentions that homes can lose value, it’s just like the stock market – good investments (non-bubble) will eventually go up. If you live in California or Florida, this probably is not true.
Home Paid Off Doesn’t Mean No More Bills
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Even with my home paid off, there’s still property taxes and home insurance. That’s tiny compared to a full mortgage (at least for me – depends on where you live), but it’s something you have to consider.
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Becky@FamilyandFinances you are correct. When you make bi-monthly payments the lender will generally hold the money until a full payment can be made. They invest that money until the payment is due. So, in effect, you may be paying a fee and the lender is earning interest on your money.
Another thing most people do not know is that your payment is not really due until the late payment date. I formerly worked for a banking association that had a mortgage division that supported the banks. I was made aware that they were laughing at the fact that I made my payment on the 1st of the month when everyone else in the company paid it on the 15th.
Another thing, I believe all lenders require escrow accounts. They want to ensure that you keep your taxes current and your home insured as they are the one who stands to lose if you fail on either of these.
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You have a larger mortgage interest deduction on a 30 yr mortgage by the 15th year than you have on a 15 year mortgage. So if you want to pay a mortgage off in 15 years, choose the 30 year mortgage, and make the extra payments to a sidefund (or investment). At the 15 year mark write one check to pay off the mortgage. This way you continue to get the maximum interest deduction. Also if you hit a financial bump in the road in this scenario, you can draw off of the money in the side fund. Do the math. Donzi
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My experience with WaMu is that they will apply your “principal payment only” check to future payments at the drop of a hat! I tried making extra principal payments by check writing that on the line, and they applied it to a future payment. I did the same thing again, adding a billstub and writing down the amount to be paid to principal on the stub, and they still applied it to future payments. I had my bank’s bill pay send them money shortly after making a monthly payment, and the same thing happened. They have their own autopay system where you can set up an autopay to take money from an account every month, but it pretty much has to be the same amount of principal added every month. I wanted to do the snowflake method of paying extra money when I got it. $200 here, $7000 there. Instead, I had to check online about 3-4 days after every payment, and then call up WaMu to have them reverse their “mistake”.
It’s now been 6 weeks and one day since making the final payment on my mortgage, and I have not yet seen any statements from WaMu saying I have a zero balance, other than the one I got at the bank when I gave them the payoff check. They’re required to send you all your payoff paperwork within 6 weeks. Hmmmm!
One of the benefits of paying off your mortgage is the guaranteed return, no matter how small it may seem, it is guaranteed. Because of the wonderful idea of paying off my mortgage, I was really motivated to cut my expenses and save up as much as possible to pay off the mortgage. I did cash in some investments (which have since would have lost a lot of money had they been invested!!) but mainly I made some long term changes, such as shutting off cable, getting rid of a storage unit, ending certain subscriptions, etc. I would not have been so motivated to try drinking powdered milk if the savings would have gone into an investment that may have been “lost” in a down market the next day anyway. I am one to invest aggressively in my 401(k) and other retirement accounts, so investing in my own house is a good diversification (for me).
Now that my house is paid off AND I have reduced spending in other areas, my emergency fund will last me a heck of a long time. Thank you, JD (and other contributors to GRS)!!!
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I am a customer service representative at a mortgage bank (yes, you love calling up and yelling at me) and I wanted to put my two cents in on everything people have been saying. Lots of good advice out here, I only wish you guys were the ones calling me on a daily basis.
With regards to prepaying the loan compared with investing the money. Neither of these tactics are a bad idea. Whichever you feel comfortable with will benefit you in the long run. Each has its own unique benefit. Prepaying the loan a little bit each month, or in a lump sum annually will accelerate the amortization schedule on your mortgage(30 yr, 20, yr, 15, yr, etc.) saving you tons in interest in the long run. Most people don’t realize that when they finance a home, that the interest they pay is greater than the principal balance they take out. So anything you can do to reduce that is great savings. It’s a general feeling in the industry that the market will rebound… eventually. When that will happen, who knows. This current mortgage situation is unique in the fact that so many loans are defaulting due to many reasons (take your pick… predatory lending, ignorant borrowers[unfortunately the most common reason], rising rates, etc.), gaining as much equity as possible to safeguard yourself from falling property values and an unstable market in general is an extremely valuable asset. Nobody knows what’s going to happen so why not put yourself in the best possible situation. As they say, hope for the best but prepare for the worst.
Bi-monthly payments… don’t bother. Stupidest thing banks offer. 9 out of 10 banks charge for the service, and if yours doesn’t, in an effort to safeguard the bottom line they will soon. There’s usually an enrollment fee and a service charge each time the bank drafts the payment. The payment isn’t sent to/credited to the mortgage until the FULL payment is received not the first ‘partial’ payment. Translation: The bank earns interest on your money for 2-4 weeks… you do not. A large bank might service anywhere between 200,000 and 800,000 loans. Approx. $1,000(average payment… maybe) x 800,000 loans… that’s alot of interest they make… then it happens again next month. Prepaying the loan monthly, or making 1 full payment each year towards the principal does the same thing the bi-monthly programs do. But it’s free.
Interest on Escrow… don’t count on it. Somebody commented on it, it’s very uncommon. Whether you have it or not depends on the state you live in. For those that do have it, interest earned on an escrow account is usually so small it makes no difference as to whether you have it or not. We’re talking cents a month here… maybe a few dollars a year. If you can discipline yourself and pay taxes and insurance on time, do it. Create a money market account for your own personal escrow. Earn interest and make your payments from there. Remember the banks RESERVE THE RIGHT (remember the home is the collateral on the loan so the bank WILL protect its investment) to pay delinquent property taxes and expired insurance policies (lender placed policies are ALWAYS outrageous) and force place an escrow account on you. This causes a large monthly payment increase because not only is there a negative balance in your escrow account, there SHOULD be a positive balance so the bank can pay taxes and insurance moving forward. This causes the escrow account to be substantially short at its inception.
I guess the bottom line is if you’re disciplined and responsible… you can really make your mortgage work for you. Whether you invest the money or prepay the mortgage, you’re only helping yourself so keep it up.
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Great read!
In addition to the “risk of investing” and “peace of mind” arguments, there’s another psychological reason to choose paying off a mortage over investing.
With investing, you may tend to think of your returns as extra income which is of course what it is. And it’s human nature to want to spend some of that extra income. Although you might plan to save enough investment earnings to “beat” the rate on your home mortgage, you might be tempted to spend a big chunk of it on a brand new shiny car.
So unless you are a very disciplined, investing might cause you to lean more towards consumption than you would otherwise. Still many people choose the shiny new car (along with tons of other material things) over being free from debt. Of course, you can pay off debt as well as invest so it’s about finding the right balance for you.
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