Mortgage prepayment made easy: Own your home in half the time

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.

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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brad
brad
12 years ago

I’m curious about the costs that you say are associated with switching to twice-monthly payments; does the bank add fees or something? I chose twice-monthly payments because the savings on interest over the long term are significant. In addition to twice-monthly payments I’m also making extra payments toward my principal but using a somewhat different strategy than yours: instead of making those payments every month, I sock away what I can into an ING account so I can earn interest, and then once a year I will make a big payment from that toward my principal. The advantages of this… Read more »

J.D.
J.D.
12 years ago

Brad, good question. I’ve added a bit of clarification. Yeah, there’s some fee to sign up for this. We did a similar program on our last mortgage and there was no fee, but our current mortgage has one. Also, I don’t like the idea of having to write a mortgage check every two weeks. I realize these are minor annoyances, but they’re enough to make me like that option less than the plan I chose.

AD
AD
12 years ago

My fiance and I are planning to build a house in about two years on a lot we purchased last year. I think I’d like to pay off the home early, too. I get the logic behind investing instead of prepaying the mortgage, but it IS a psychological thing. I paid off all of my credit card debt last year, my fiance is getting his paid off this year, then my vehicle will be paid off next (his is already paid off). To then tackle the mortgage and to know that we’ll (hopefully) be 100% debt-free in maybe 15 years… Read more »

JM
JM
12 years ago

Paying off a mortgage is *not* mathematically inferior to investing. Paying off a mortgage is guaranteed to save money. Most investments are not guaranteed to make money. The investment that is closest to guaranteed is a government bond. At current interest rates, paying off a mortgage mathematically makes sense, when doing an apples-to-apples comparison. Read Consumer’s Reports closer, they say “chances are” you will do better by investing. They acknowledge the risk involved in investing. Before making these kinds of decisions, know what risk you are accepting. If the risk is suitable, then invest, if not paying off your mortgage… Read more »

Kaleb
Kaleb
12 years ago

Brad, Many banks/mortgage companies allow you to use a bi-weekly payment option so you only have to pay 1/2 your mortgage once every two weeks but they’ll charge something like $3 each payment. J.D. and Brad, Brad says “the sooner I can pay off my house, the more freedom I will have to cut back on my work or switch to other work that pays less but is more enjoyable. My fixed monthly expenses will drop by more than 50 percent, so if I decide to stick with my current job I’ll also have a lot more free cash to… Read more »

Philip
Philip
8 years ago
Reply to  Kaleb

The problem with that kind of thinking is you’re assuming you’re not gathering any liquid assets or emergency fund. Of course it’s dumb to dump all your money into your mortgage if you aren’t ALSO putting money assist for emergency fund and other investments. Tackle your outside of mortgage debt first with avengnce with a small emergency fund then raise your emergency fund once debt outside of mortgage is gone and then slowly grow investments and tackle your mortgage as fast as possible. If you skip to paying off mortgage before completing the other steps of course you may be… Read more »

Willie
Willie
12 years ago

Do not forget about deducting your mortgage interest on your taxes. When you figure that in, the 8% ave return in the stock market looks a little bit better.

brad
brad
12 years ago

@ Kaleb and JD: That’s crazy about the banks charging more for biweekly payments. My mortgage is with ING, so there are no fees of any kind, which is great, and my transfers happen automatically twice a month from my ING account to the mortgage. I didn’t realize other banks charged for this. @Kaleb: While it’s true that there’s an opportunity cost in terms of lost investment income when you prepay a mortgage, you also have to remember the savings in interest (not just principal). On a 30-year mortgage, the amount you ultimately pay in interest can be more than… Read more »

rich
rich
12 years ago

Great post. I subscribe to both beliefs: the mathematical superiority of investing, and the psychological boost from paying down debt. And despite advice from most financial resources, I decided in the past to pay extra on my mortgage every month. That is, until the last few years. I talked with a tax guy who agreed paying off debt was important, but he explained a severe disadvantage to prepaying the mortgage: your mortgage starts over every month. If you make an extra 3 payments every year, and one year fall on hard times, do you think your bank is going to… Read more »

NoDebtPlan
NoDebtPlan
12 years ago

Nothing wrong with paying off your house! The thing about investments is there is risk involved. Sure, there is risk in owning your house, but if you pay it off early that is a guaranteed return. You could lose everything with the investments.

We’re paying as much as we can on our 2nd mortgage (8.125%) simply because I base our investment returns on a conservative 8% return. Sure there is the tax deduction issue, but we probably won’t be able to deduct the full amount.

Tana
Tana
12 years ago

On thing they don’t talk about much is the situation we are in. We’ve owned our house for 5 years now, but my husband has gotten his masters and now we’re looking at moving to an area where we will have to pay 50% more for a comparable house than what we have now. 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… Read more »

Kaleb
Kaleb
12 years ago

@rich: I like you, let’s be friends. This is exactly what I mean! I just got out of credit card debt this month ($11,000 or so paid off in 6 months). Now, like J.D. I have tons of extra money each month. If I prepaid my mortgage $2,000/mo, I’d have it paid off in less than 5 years. But if I saved $2,000/mo and got 6%, I’d have enough CASH to pay my mortgage off in 5 years, and that’s not counting the tax deduction! It’s the same thing, but with more security! It’s the smart thing to do!

Philip
Philip
12 years ago

I have just purchased a house, I was not able to put down enough, so I have to pay PMI on the loan until I get it to 80%, does that make enough difference to be worth paying extra until that 80% mark is reached? My payments are about 1300/mo and I believe the PMI is around 90/mo that is lowered each year.

J.D.
J.D.
12 years ago

Great point, Tana. I’m actually preparing a review for a book called The Kitchen-Table Investor by John Wasik. He has a section that explores various scenarios, explaining if it makes sense to accelerate mortgage payments or not. He actually says that it makes more sense to prepay a mortgage if, like me and Kris, you plan to stay in the same place a long time. In the scenario you describe, his advice would be to rent, I think — it’s generally cheaper and gives you more flexibility. If you have time to build equity, then it makes sense to buy… Read more »

J.D.
J.D.
12 years ago

@Kaleb

I agree that your plan makes a lot of sense. But, again, I look at this move as a form of diversification. I wouldn’t do this if it were my only form of investment. Right now I have a three-pronged approach: retirement funds, high-yield savings, and mortgage acceleration. By spreading my funds out, I’m able to pursue different goals at the same time.

FMF
FMF
12 years ago

Gotta agree with Rich:

“The mathematical superiority of investing and the psychological boost from paying down debt.”

There’s a “win” with either of these. Pick which works best for you and go with it.

Dean Jackson
Dean Jackson
12 years ago

I just refinanced to a new type of mortgage that allows you to put money in to an equity account that lowers your payment but still allows you access to the money if you want or need it. I didn’t like the idea of paying extra money on my mortgage and not being able to get the money back if I wanted it…or not having my payment adjust because of it. The mortgage has a payment that’s recalculated every month based on the balance you have that month. It’s a perfect place to park cash, or emergency funds, or savings…because… Read more »

FourPillars
FourPillars
12 years ago

I don’t agree that the mathematics support investing over debt repayment. The fact is that all investment decisions have to considered in the context of the risk involved. There is no guarantee that expected investment returns will actually happen whereas the debt interest is fairly certain.

Personally I do both in a ratio that I’m comfortable with.

Mike

Dennis
Dennis
12 years ago

I think this is a personal decision. If you are more comfortable with a mortgage, then you are better off investing the extra money. If the thought of owing a bank hundreds of thousands of dollars in some cases makes you sick (like myself) then you are better off paying off the mortgage as soon as you can.

Canadian Dream
Canadian Dream
12 years ago

Excuse my ignorance here, but what tax would you have to pay on that 8% investment return? Once that is factored in how much is your real return after tax. That is what you should use to compare to your mortgage interest rate to see if it makes sense to pay it off. Perhaps another overlooked factor is everyone buying houses they can’t afford. If you need a 30 year term to buy a house, in my mind you shouldn’t own it. 25 year term should be the max and better yet do it in 20 or 15 years. I… Read more »

Don
Don
12 years ago

Willie, don’t forget that the mortgage interest deduction is only valuable if you’re a fairly “rich” person. My mortgage interest deduction has never beat out the standard deduction.

Without a deduction, removing the expense of the mortgage is worth more than the same return on an after-tax investment (because you’d have to pay the taxes out of your gains). So that 6.25% starts to look very competitive against stock market returns. Since he’s maxed out the Roth, this could really be the relevant scenario for him.

Patti
Patti
12 years ago

Remember to make sure that the second check goes only toward the principle. I think David Bach mentioned using this method in “Smart Couples Finish Rich”, but a few times his second check was not applied specifically to the principle. You have to keep an eye on those mortgage companies!

Anne
Anne
12 years ago

@brad: re: “instead of making [extra principal] payments every month, I sock away what I can into an ING account so I can earn interest, and then once a year I will make a big payment from that toward my principal. The advantages of this approach are 1) I can earn interest on those payments instead of giving the money to the bank immediately…” Pardon me if I’m misunderstanding what you’re saying, but the way this is written, it doesn’t make much sense to me. If you put the money in an ING account, it starts earning maybe 3.5% interest?… Read more »

Willie
Willie
12 years ago

Don,

Ever since owning a home between mortgage interest, taxes and charitable contributions, I never have took the standard deduction. I do not consider myself a “rich” person.

Also if you contribute to a mutual fund monthly for years, you only are paying taxes on the dividends you receive at the end of each year. If you invest in growth stocks, many of these companies do not declare dividends so your tax liability is very minimal. Granted when you cash out you are going to pay taxes but your investment has had time to multiple and grow.

KC
KC
12 years ago

I’ve often wondered about the escrow part of a mortgage. Why do people roll in their insurance and taxes into their mortgage? Isn’t that basically taking out a long-term loan to pay those instead of paying them out of pocket with no interest when they come due?

Betsy Teutsch
Betsy Teutsch
12 years ago

For higher income families, the mortgage interest is a huge deduction.
Also, military and clergy families have a”parsonage” benefit, where the costs of their housing comes off the top of their return. So it’s not in some households’ “interest” to pay off early. Of course no one should strap themselves into mortgage payments so high they can’t afford them. Unfortunately we are seeing the results of that all over the place…

Jeremy
Jeremy
12 years ago

I’ve had a mortgage with Countrywide and now with First Horizon. They both had fees when you set up autopay. Turns out this is pretty dumb when you consider nearly every bank has FREE bill pay. For example, with a HELoan we were doing every two weeks with zero fees that way. Later, when I switched jobs and got paid just once a month, I changed the payment to reflect that. Super easy! You can even to one-time payments as well. I also pay a bit more than my regular payment but that’s more for convenience than anything else: $1000/month… Read more »

Leslie
Leslie
12 years ago

Honestly, I am kind of tired of being told that prepaying the mortgage is foolish. As JD says, do what works for you. Everyone has different goals and different situations. For example, when we first moved in to our house in 1997, we put down 10% as a down payment and thus had PMI to pay. At the time we did not have children and we were both working. We were maxing out all of our retirement funds and had a very healthy emergency fund. So, we started paying extra on our mortgage in order to get to 20% equity… Read more »

Cheapest Man
Cheapest Man
12 years ago

Great article! My wife and I are paying off our debt right now via the ‘debt snowball’, then the emergency fund with be funded..and then I’ll revisit this post about paying off our mortgage. But, good tips, I forwarded this post on to quite a few folks I know.

Dave C
Dave C
12 years ago

@Kaleb, quite the assumption you’re making that you can pull in 6% over the next 5 years. One of several crucial points in deciding to attack the mortgage, that’s a guaranteed return. @Brad, in your first post you state the “advantage” of earning interest on your mortgage prepayment for the year, I fail to see the advantage when your mortgage is 5.24% vs. ING at 3.1ish%, truth is you’d “earn” more interest by shaving it off your mortgage month-by-month. But your later post re: interest would seem to indicate you should get this. Myself, I’m full steam ahead on paying… Read more »

CMR
CMR
12 years ago

One thing to consider that is gaining traction in the United States is a Mortgage Accelerator program (united first financial offers one). This has been a very popular program in EU and AUS for some time, but is only good if you are living within your means (something not common in many American households). It essentially works like a bank account. You transfer all your deposits to a HELOC receive a debit card and checks to draw this from. If you use this as your day-to-day bank account you should be able to pay off your mortgage (on average) in… Read more »

J.D.
J.D.
12 years ago

I wrote about money merge accounts in October. Some people love them. I didn’t want to get tied into a long-term commitment, so I didn’t consider one. The flexibility of a self-administered program was important to me.

@Leslie — Yes, “do what works for you” is very applicable to this sort of decision. The truth is, whether a person chooses to invest or to pay off her mortgage early, she’s making a smart decision. Both offer significant returns. It’s like having to choose between a trip to Hawaii or a trip to Italy.

CMR
CMR
12 years ago
elisabeth
elisabeth
12 years ago

One reason to pay off one’s mortgage is, as someone mentioned, precisely because it is a monthly bill — and one that, if you get into a financial bad spot, you can’t turn off, as you could the cable bill or a cell phone. And since you will always need a place to live, why not have one that you don’t have to worry about losing (as long as you can keep paying the taxes, of course). The psychological boost of seeing our mortgage go down was huge, much more real and satisfactory to me than watching the intangible numbers… Read more »

Niall Kane
Niall Kane
12 years ago

this is a bit like the debt snowball, it may make more mathematical sense to invest the money, but feel better paying off the mortgage.

another way to look at investing rather than prepaying your mortgage. if you invest instead of prepaying your mortgage it’s like borrowing money to invest. if you’re willing to accept the risks mentioned above so be it.

personally, i do a bit of both. (don’t want all my eggs in the one basket)

brad
brad
12 years ago

@Anne and Dave C: you’re right. I’m a dummy 😉

I must not have been taking into account the fact that the bank recalculates the amount of interest for each payment based on the actual remaining principal, but in fact that must be what they do.

JerichoHill
JerichoHill
12 years ago

I also subscribe to JD’s notion that prepaying your mortgage is one element of diversification. My wife and I max out our 401Ks, I have an IRA and she has some low-cost managed funds. We invest in commodity ETFs, and we prepay our home mortgage aggressively (like…4x Givens).

Chris
Chris
12 years ago

@CMR
Have you or anyone you know tried United First Financial?

It sounds like a decent idea but I am skeptical.

Meenakshi
Meenakshi
12 years ago

Here’s another idea. Talk to your present mortgage company and see if they have something called an “Accelerated Ownership Program” wherein they will, FOR FREE, re-calculate your mortgage and give you the prevailing interest rate for a lower term (if you so prefer) WITHOUT CHARGING YOU A SINGLE DIME. The only thing you’d be on the hook for would be any notary fees for getting the documents notarized and sending it back to them. We just did this with Wells Fargo and are down to a 15-year term (down from 6.25% to 5.375%) with only a $23 difference from our… Read more »

jenolyman
jenolyman
12 years ago

DH and I have been paying extra money on our mortgage for two years and will continue to do so at an increasing rate. Every year when DH gets a raise, 1/2 of the monthly net increase will be applied to extra principal payments each month. Since we’ll be budgeting for a larger payment than we actually have, if we come upon hard times, we can cut back to the actual payment and have some wiggle room. The other half of the raise will be for COL increase and increase retirement savings. This may not make sense to some, but… Read more »

Frugal Dad
Frugal Dad
12 years ago

I like your thinking on 6.25% being a guaranteed return – and you won’t find anything near that in an online savings account these days! I personally believe the freedom of owning your own home outright would far exceed the mathematical advantages of using that money to invest.

Chris
Chris
12 years ago

JD, Don’t forget the power of inflation. You are prepaying to eliminate payments 20-30 years in the future. Since you have a fixed mortgage, the payments in the future are the same as today but in real terms, they will be “reduced” by the inflation rate. For example a $1681 payment today will only “feel” like $907 in 25 years at a 2.5% inflation rate. Or if you assume 3% it is only about $803. My wife and I are in our early 30s and our incomes are increasing faster than inflation while our mortgage is fixed. We thought about… Read more »

Andreas
Andreas
12 years ago

You’d have $1,386.60 left over, not $1,7000 🙂 Taxes and insurance won’t go away (OK, you could not insure your house since you own it outright … but that’s a large risk for the investment of your lifetime).

Pop
Pop
12 years ago

“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.”

I believe the correct way to look at it is, you’re knocking off the LAST payment at the end of the loan term, not next month’s payment. I think it’s worth doing for a number of reasons, but it’s not quite the “bargain” you’re claiming.

Dave C
Dave C
12 years ago

I just wanted to chime in again re: CMRs pimping of United First Financial. At worst, it’s a scam. At best, they provide nothing you couldn’t figure out and do on your own and then overcharge you for it. DON’T fall for it. If interested, I’ve got a link of my own for the truth on UFF: http://www.fatwallet.com/forums/messageview.php?catid=52&threadid=741118

Jennifer
Jennifer
12 years ago

This is an interesting tactic to prepaying the mortgage. Even if I can’t do this every month, paying double the amount of the principal when I can is a great idea. Thanks!

Gnashchick
Gnashchick
12 years ago

I have a very modest, low interest, fixed-rate, 20-yr mortgage so it doesn’t really make sense for me to pay it off early.

However, for the psychological boost, I make an extra mortgage payment every year. Instead of coming up with the whole chunk of change at once, I take the amount of one month’s total payment and divide it by 12, and then add that amount to each monthly mortgage payment. It will cut about 4-5 years off my payment term, and costs about as much as a dinner and a movie for 2.

Pex
Pex
12 years ago

We should weight the comparison with proper calculation. I do have my own calculator scripted a while back, but unfortunately it’s in another language and I don’t have access to my own FTP at the moment.

Base on my calculation for a $200,000 mortgage at 5.5% interest rate for 30 year fixed, and started back in January of 2006.

Current payment: $1,135.58

If you begin making additional payment starting January of 2008 at $250 a month.

New monthly payment: $1,385.58
Payoff period: 20 years and 10 months
Interest saved: $69,244.82

Essentially by making $250 additional payment a month, you have saved almost 70k in 9 years.

Pex
Pex
12 years ago

I guess you can just google a calculator:

http://www.real-time-rates.com/r/help/extra_payments.asp

b-bo
b-bo
12 years ago

good post. 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.

Terra Andersen
Terra Andersen
12 years ago

I’ve never heard of this strategy before, but it makes complete sense. Being that I am in my 20’s, information like this is so wonderful to learn before making the decision to purchase a home.

Given that I was only 5 years old when this book was written, it’s amazing to me to think that that information would still hold true today… but it most definitely does.

Thanks for sharing – Great advice!

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