Time For Another Extra Mortgage Principal Payment?

If you have a mortgage, do you know when it will be paid off? Have you though about paying extra and making that day come earlier? The commonly discussed biweekly accelerated payment plan is the same as making one extra monthly payment each year and knocking off about 5-6 years from a normal 30-year mortgage. For example if your mortgage is $1,200 per month, you would pay an extra $1,200 a year ($100 per month.)

Here’s the effect of one, two, and three extra monthly payments per year on mortgage paydown. The specific numbers are for a $480,000 mortgage at 5% fixed for 30 years, but the general effect for all mortgages is similar.

As you can see, the more you pay down, the smaller the effect because you give yourself less time to compound the interest saved. If you pay down your mortgage principal, you are effectively earning your interest rate. For example, if you have a mortgage at 5% interest with 25 years left and pay an extra $5,000 towards principal, that’s basically the same as having that $5,000 earn 5% for 25 years (taxes tend to wash out if you assume mortgage interest is tax-deductible).

Good Investment?
But is earning 5% a year for 25 years a good deal? First, you must remember that this is virtually a no-risk 5%. A fair comparison would be with bonds backed by the US government. Let’s look at how the current U.S. Treasury bond yield curve.

We see that it’s currently yielding about 4.4% for a 30-year bond and 3.8% at 15 years. Keep in mind that federal bond interest is exempt from state income taxes, which will boost the effective yield for certain residents. For me, it is nearly a wash at the 30-year mark. However, if I pay down my mortgage as fast as I plan to, I’ll only have about 15 years left. Earning 5% for 15 years by paying down my mortgage is better than earning 3.8% in a Treasury bond.

Now, people will say that they can easily earn more than 5% over 30 years. Others go even further and believe that you should never pay off your mortgage. This almost always means taking on more risk, whether in the stock market or wherever. While we should definitely take some risks in our investments overall, 2008 should remind us that taking on extra risk is not something to be taken lightly.

Another thing to consider is that you’ll be losing liquidity on the money being put towards your mortgage, as it can be costly to extract without selling the house. But I lose liquidity on everything I put in a Roth IRA and 401(k) as well. As long as I keep enough liquidity in my emergency fund or elsewhere, I don’t worry about it.

Flexibility
Now, there is a good possibility that at some point I will be able to get greater than 5% in a very low-risk investment, most likely in a time of high inflation. In that case, I’ll simply buy that alternate investment, keep the difference, and stop making extra payments during that time.

I’ll also have flexibility in other areas. If I move early, I’ll be earning 5% for even less than 15-years. If I decide to rent out the house, I can possibly refinance for a lower mortgage payment over a longer period for cashflow reasons.

Execution
Basically, as part of the big picture of your finances, paying extra can make sense. My mortgage is already automatically withdrawn from my checking account each month. So far, I’ve been making my extra payment manually in a lump sum by writing a check. I haven’t made my payment this year, and I am debating whether to switch to a constantly higher monthly payment instead. My bank allows me to make extra payments towards principal each month on an automatic basis for free. One less thing to worry about.

Comments

  1. mortgage interest is tax deductible, but u have to pay taxes on the interest on CD…

    whatever it is, i paid off my house completely. Lets me reduce my worries about the economy now and the future.

  2. Hmm, for me I can earn virtually the same rate as my mortgage by putting my extra money in a high interest checking account. Plus I don’t need to sell my house to access my money.
    The idea of buying a 30 year CD with a 4.75% yield doesn’t appeal to me, but if your alternative is investing your money very conservatively, then paying off your mortage is worth it. A young investor should still be taking chances and will have time to recover from the recent marked crash. There are worse things to do than paying off your mortgage, but I think many people do it more for emotional reasons than for economic ones.
    I guess if I had a 100,000 emergency fund like some people do then sure I’d do this.

  3. Paying it down early is appealing …

    However, should you lose your income long term and need money, getting it out of your house as a home equity loan is much tougher than cashing in a CD or selling off some funds. When it comes to lending money, banks don’t care about your home equity as much as your income/employment status.

    We are seeing a lot of people out-of-work for 12 or 18 or more months or finding work but in much lower-paying jobs in the current climate, despite their abilities, skills and education. I don’t see that stabilizing any time soon and believe we need to re-think how much should be in an emergency fund (for those in the fortunate position to re-think it).

    Makes more sense to me to place the money into other places for access and diversity sake.

  4. Ahh, the old argument of paying off/down or keeping mortgaged to earn a higher return elsewhere. The latin word for mortgage means “death grip”. I think it all comes down to a matter of preferance. I personally enjoy the feeling of not giving my money to a bank and knowing that no-one can take my house away from me besides my lack of paying taxes or mother nature. As someone that has been investing in the market etc., the returns have not warranted mainting a mortgage. I look at economies/ markets such as Japan and think the argument for not paying the mortgage off makes no sense. I really think that the depression era generation has it right, live within your means, remain debt averse & invest conservately.

  5. Bottom line for me…if you have enough to live for 1.5 years, pay down your mortgage. So what are the benefits….the extra left over by not paying the mortgage (after you paydown), you can invest..not to mention without worry. Even if you loose your job, you can work at grocery store and survive. Think of a mortgage as a two part entity. A fixed part is equal to the purchase price and variable part is a interest. If you owe on fixed part, you pay interest. If you own the fixed part, you loose interest. Owing makes sense when variable part is cheaper for e.g. when money market interest are too high or any other way of generating return. To own makes sense when variable part is expensive foo e.g. right now MM interest are too low and it’s better not to pay 5% mortgage. What it boils down to the fact that how easy to manage the variable part – do you want to buy 30 year treasury (it has risk though minimum) or assume that investing in stock will return much more or payoff the mortgage and get sure 5% return and do the tricks later.

  6. I paid off my mortgage in 10 years, and I’m happy I did. But my loan interest rate was initially almost 7%, so it was worth it at the time. But now that the rate is so much lower, I don’t know if I would or not!

    I have to admit, I do sleep very sound at night…

  7. Since mortgage interest is tax deductible, wouldn’t the effective interest rate actually be lower? For example, if you are in the 25% tax bracket, the 5% is effectively 3.75%.

  8. Jonathon, you said
    “I am debating whether to switch to a constantly higher monthly payment instead”

    If you did switch to putting adding an extra 1/12th to your mortgage every month instead of saving and putting it in at the end of the year, over the course of your entire loan, you would save a little more then a payment. (1.39x a payment from a sample calculation i just made on a 30 year note)

  9. Michael says:

    if your mortgage interest rate is 5%, since it is tax deductible, assuming your marginal tax rate is 28%, would make the effective interest rate 3.6% (5 * .72). The effective interest rate is even lower if you the interest is state tax deductible (?)… And if you’re already years into your mortgage payment, the effective interest rate is even lower since you’ve already paid more interest in the beginning years. This is not to say ‘don’t pay down your mortgage’, but the point is that saying 5% guaranteed return is a bit misleading.

  10. Agree with the pre-tax/post-tax comments above.

    However, in your case (15-year expected payoff) the appropriate comparator isn’t really a 15-year bond because only the first excess payment will actually be at work for the full fifteen years. If you make monthly excess principal payments the second payment will be at work 14 years, 11 months, and so on, until the 179th payment is only invested for one month, and the 180th for no time at all (as part of the final mortgage payoff).

    So to get an appropriate opportunity cost yield you’d need to find something with considerably less maturity than the 15-year, and you could use a weighted-average maturity of your prepayments to estimate the right bond to use. In any case, given an upward sloping yield curve you would be earning even less in that instrument than the 15-year bond and less than the avoided interest on your mortgage than your analysis suggests.

  11. The “real” benefit of mortgage interest deduction is the amount of itemized deduction “above” standard deduction. It’s not as big as people think it is…

  12. Some Dude on the Internet says:

    Why not have the best of both worlds. Set up a plan to pay off your mortgage in, say, 10 years. But instead of paying the extra principle to the lender, bank it in a safe, liquid investment. Then in 10 years you can decide whether to use that money to pay off the loan. In the intervening time, however, you would have had that money immediately available for emergencies or other uses.

    After all, just because you are paying extra every month now, your monthly payment doesn’t decline, thanks to those wonderful amortization tables. Right?

  13. Michael says:

    Those of us who live on east/west coast, such as this site’s blogger, the mortgage interest each year is way, way above standard deduction. With addition of potential capital losses and charitable contributions, as well as high state income tax, the tax advantage is huge.

  14. All of you who can make a 6%+ return in the stock market, after taxes, year in year out, no problem in today’s world of handouts and bailouts, here is a question for you –
    Why don’t you take a cash out refinance loan out on your home and just go get filthy rich? Any takers? …………………….Anyone?

    To the tax deduction people you paid $1000.00 in interest to get mabey $250.00 back on your tax return. Yawn………………Wow.

    The “mortgage interest is OK crowd” also tends to buy more home than they can afford and upgrade homes with a new higher mortgage when they don’t need the upgrade.

    Mabey try Emergency fund first, 10-15% of salary in Retirement accounts (good stock pickers go crazy!), then leftover money should go to mortgage principle. Then you will be prepared for an emergency, can retire someday, and not be upside down on your home, so you have the freedom to take the out of state job, with cash in your pocket, short sales don’t count.
    When your mortgage is paid off, early, then you have tons of money to invest to really build wealth. Also, you can sleep at night too?

  15. I’ve locked a 30 yr fixed at 4.375%. Given the state of current US inflationary outlook and knowing that inflation averages 3.6% annually over 30yrs, why would I want to pay off my mortgage indeed, when my effective interest rate is only 3.28%?

    Yes, it does hurt to see that during the first decade most of the payment goes towards interest and very little towards principal, but I’m still not convinced that paying down your mortgage today is a good thing (assuming you have a rate below 5.5%).

  16. I paid off my mortgage early and am enjoying the freedom that comes with it. For me it is the best insurance against a down economy. With my emergency savings I can live much longer without an income – with no mortgage my monthly outflow has dropped significantly. After killing the mortgage I directed a good chunk of the monthly payments to optional monthly mortgage fund contributions. It took me a long time. I started slow but gained some momentum as I got closer. You can do it.

  17. My mortgage interest is not tax deductible, and that makes prepaying the mortgage more attractive.

    And for those who do deduct your interest, remember the only part that is “effectively deductible” is the part beyond what your standard deduction would give you. There’s plenty many folks for whom the amount effectively deductible isn’t that much.

  18. Paying down a mortgage is not like buying a bond. Your house is not guaranteed to keep its value. “virtually no risk” BS – real estate does have risk – natural disasters, gangs moving into the neighborhood, etc.

    If you bought a $500,000 house and pre-paid your mortgage, then your house dropped to $250,000 and you had to move – you are out a lot of money.

    No bank write-down or short sale for you.

    If you lose your job and you pre-paid all your money into a mortgage (but the mortgage is not yet paid off) foreclosure is in your future, however, if you had kept the money you could continue to make payments while being unemployed.

    Lets say your roof starts leaking and you lose your job – can’t get a loan with no income, but if you had kept the money, you could afford to put a new roof on.

    Risk goes both ways.

  19. JT, I don’t think one can count on short sales and bank write downs, personally I think that is BS anyway.

  20. JT,

    All I know that if I payoff than I have a roof to sleep under no matter what the value of the house is and I am sure I can earn enough to pay of my bills.

    Year over year it is proven that real estate is a way to go – we are not talking about gambling with real estate but owning one that you need.

    Cash is a piece of junk – everyone advise that you need to invest than why not start with the one that you need and than take on the next important one. With every country printing money with bailouts, cash is diminishing in value so buying real estate makes more sense since it will appreciate with inflation.

  21. The other risk of pre-paying a mortgage is inflation. When you give your money to the bank – its dead. As inflation marches on, your “equity” earned by pre-paying diminishes. If you had kept your money on your side of the balance sheet and invested it – you can outperform inflation.

    Real Estate’s value is leverage – prepaying a mortgage reduces that leverage.

    Year over Year investing in the stock market is the best long-term strategy to beat inflation – reducing the money you put into the stock market over the long-term is not a good strategy unless you don’t have the discipline to invest.

  22. In an inflationary environment it is very good to have low interest debt. It gets deflated away. Most arguments for paying a mortgage off early are more emotion based than logic based.

  23. People predict inflation and deflation all the time, but I have stopped listening. Everything is always “inevitable” until it isn’t. If inflation happens, and I can get 5% return with no risk, then I’ll stop paying down my mortgage and buy something else.

    I agree that the possibility of a “strategic default” is something to consider if your house value is less than mortgage value and you’re close to just walking away.

  24. I don’t think anybody said the underlying asset (house) is risk free. But, the paying off of the liability is, in fact, risk free – you no longer owe the money! The same thing goes for paying off any debt (credit card, car loan, etc). Many reasons why you should or shouldn’t pay off a mortgage, but paying down say a 5% debt is the same as having a 5% risk free CD. Let me know if you find one these days.

    I also agree with one of the other comments. If you think that having a mortgage is a good thing, then by all means go out and take a home equity loan for ALL of your equity and invest it. Same thing. Exact same thing!

  25. Did everyone take a max Loan To Value cash out loan to “beat inflation” yet. I just did, now I will never be effected by inflation for the next 30 years. I also agree that a short sale should be a part of your short and long term financial plans. I am sleeping better already, with more debt. Who would of known?
    Thanks.

  26. So, I recently decided to payoff my mortgage – I’m 5 years into a 30 year fixed mortgage at 5.25%. I wrestled with keeping the funds invested, but decided to payoff the house whenever I introduced a new variable to the forecast – what is the likelihood that I would spend part of the funds? I would be much more likely to spend part of the money if it is invested in CD’s, bonds, stocks, etc. If I spent only 10% of the invested funds, that suddenly makes the option of paying off the mortgage much more attractive.

    Another thing to consider is the amount of time – 30 years. Look at how much has changed in the investing world over the past decade! There is a lot of complexity and time that must be spent to keep money gainfully invested over 30 years. I’ve got enough time spent trying to keep the 401k out of trouble and to be honest with you, it’s track record of 15 years is not much better than 5% growth.

    Finally, there’s no risk in paying off a debt. Look at how many “safe” investments of previous years have proven to not be so. Now there’s Greece, its impact to the euro, questions of whether US is headed for the same fate, and on and on. Sure, some folks say there is greater opportunity in this investment and that investment…. but do you know how many of those I’ve seen fail in the past ten years?

    In the end, I chose to put the money against my debt where there’s much less risk of me choosing to spend some of it just because it’s there.

  27. Albrecht says:

    I’ve paid off my first 15-year mortgage (151k borrowed) in 7 years, and now, after buying a second house (30-year 240k borrowed) – on a fast track of prepaying that one off. After a year, it’s already down to 219k. Besides prepaying in relatively small payments monthly, whenever I had a couple of extra thousands, I’d send it the same way as well. Trust me, the more money you throw towards getting rid of that debt, the more it works in your favor. It really does make a world of difference.

  28. a lot of people are confused about tax deductible. My friend put money into bank, earn 2% interest and pay 4% on her house mortgage because under impressing of tax deductible which is totally wrong, example:
    $1,000 mortgage @ 4% mortgage, pay interest $40/year, get Federal tax $10 (25% rate), actually pay interest $40/year
    If I have $1,000, put it in CD @ 4% rate, I get $40 interest/yer, then pay $10 to Fed tax (25% rate, same), I earn $40 interest, even out the mortgage interest payment
    Conclusion: we should disregard the Fed tax, compare direct % to %
    If investment is higher then 4%, put this $1000 to investment.
    If investment is lower then 4%, put this to mortgage principle.

    Personally, I pay mortgage whenever I have extra money, it is like earn fixed 4% CD, investment can be 50% gain or 50% loss.

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