There are many exciting things about buying a new home, from meeting your new neighbors to upgrading your home decor (with reason, of course) to starting to build equity in what’s likely to become one of your top sources of wealth.
The flip side, of course, is that suddenly owing a bank thousands upon thousands of dollars can be stressful—as is the idea that it’ll likely stay that way for many years. That may have you wondering whether it’d be wise to pay off your mortgage sooner.
The short answer? It depends.
On one hand, paying off your mortgage early means you can’t use that money to accomplish other, perhaps more pressing goals. “People are woefully undersaved,” says Greg McBride, Bankrate’s Chief Financial Analyst. “Paying down low-rate, tax-deductible debt [like a mortgage] is a low priority if you aren’t saving enough.”
Because homes aren’t a liquid asset that you can easily tap in times of need, if you realize your emergency savings is lacking, allocate any extra dollars you have at the end of the month there instead. “You want to put your cash to work in other, more efficient ways, and retain your flexibility,” McBride says. “Tying up money in a home isn’t flexible.”
If you’re already on your way to a healthy emergency fund, there’s another consideration: Invest the dollars you’d put toward wiping out your mortgage early, and the payoff could be exponential.
Let’s say you have a $100,000 mortgage and an annual interest rate of 3.5 percent. Assuming a 30-year fixed-rate mortgage, you’ll pay $61,657 in interest if you make the minimum payment of about $449 (note this doesn’t include taxes, insurance or other related costs). But increase your payments by $200 each month, and you can save almost $29,000 in interest over the life of the mortgage. Not too shabby. However, if you invest that extra $200 and get a reasonable 7-percent average return, and you can have $246,000 after 30 years—or more than eight times the mortgage interest you saved.
While the math is clear, Casey Fleming, a mortgage advisor at C2 Financial Corporation and author of “The Loan Guide: How to Get the Best Possible Mortgage,” says it’s also important to consider your mindset and personal goals when debating whether to pay off your mortgage early.
“Some folks want to retire early, [while] others just want the peace of mind, knowing their debts are paid off,” he says. “While paying off your mortgage may not be the best strategy for having the biggest pile of money when you die, it’s an excellent strategy if you want to get off the merry-go-round.”
If the latter sounds like you—and your savings and investing goals are on track—then accelerating your payment schedule is a good way of eventually lowering your monthly expenses, McBride notes. But what’s the most effective way to go about it?
Some banks tout bi-weekly plans, so that instead of making 12 full payments a year, you make 26 half payments—which means you’ll submit 13 full payments by the end of the year. A biweekly plan would kill off the aforementioned $100,000 mortgage almost four years early, and save more than $8,500 in interest.
But there’s a catch: “I don’t like biweekly mortgage plans,” McBride says. “They lock you into an inflexible payment schedule, and charge you extra fees to boot.” Depending on your bank, a biweekly plan can cost hundreds of dollars to set up, and will accrue ongoing servicing fees to process each payment. This adds up when there are 26 installments a year, for decades. So instead, McBride recommends that homeowners who are steadily trying to hack away at their mortgages make one additional payment each year, or add about 8.5 percent to their regular monthly payments (so that at the end of the year, that equals one full one).
Fleming’s advice for accelerating your payment schedule is to apply windfalls to the principal balance. Whether it’s a raise or bonus, or inheritance, any extra payment you make toward your mortgage helps.
And it’s best to start early. Mortgages are structured to pay interest first, which means you’ll barely put a dent in the balance for the first couple years. Adding a little extra to pay down principal can reap big benefits, especially with a new mortgage.
Going back to our $100,000 example, adding $10 every month to the $449 base payment knocks out the loan 13 months early and saves about $2,600 in total interest. If you wait until the mortgage’s final three years to apply that extra $10 a month, you’ll only save $20 in interest, and it won’t wipe out the loan any quicker. But pay an extra $10 for the first three years, and you’ll cut two months off the life of your loan, and be $612 richer.
September 19, 2016