A little extra now will save you a bundle in the long run.
My wife and I now have two mortgages. One of them is on a rental property in my home town. I owe about $15k. The other one is on the multi-family house my wife and I just bought. We owe over $200k on that one. We got a 30 year mortgage for the flexibility, but we’d like to pay it off in less than 20 years. How difficult is that to do? The truth is its pretty easy. The other question is whether it makes good financial sense to prepay your mortgage. We can determine the answer to that with a little simple math.
Let’s start with a hypothetical. Let’s assume, for the sake of simplicity, that you can buy a $250k house with 20% down ($50k) and give back a promissory note and a mortgage for $200k at 5.5%. Using this mortgage calculator, we discover that your monthly minimum payment will be $1,135.58 per month. If you clicked on that link, you can see that just by paying your mortgage bi-weekly, instead of monthly, you can save $41,448 and knock around 5 years of payments off your mortgage. Obviously, this is one thing you can do to easily reduce the amount you end up paying on your mortgage. All you have to do is schedule your payment once every two weeks instead of once a month. You pay the same amount overall, it’s just a matter of when you hand it over. It seems like a no brainer to me.
Have you ever heard anyone say that you can shave years off of your mortgage by making one extra payment each year? It’s true. In the example we’re using above, one extra payment per year is $1,135, which would be $96.63 per month, bringing your new payment up to $1,232.21 per month. If you make the minimum payment, you’ll end up paying a total of $208,806.98 in interest over 30 years of paying down a mortgage. If you made that one extra payment per year, or $96.63/month, you’d only end up paying $167,079.11 in total interest, and you’d pay off the loan in 24.833 years instead of 30. That little bit of extra money each month cuts more than 5 years off of your mortgage.
What if you made two extra payments a year? Two extra payments per year would come out to $1,328.84/month. That would knock 9 years off your mortgage and save you $68,633 and change in interest. If you round it all the way up to $1500/month, you’ll save $99,001.79 and pay off the mortgage in 17.250 years.
Someone might tell you that mortgage interest is tax deductible. That’s true, it is. If you itemize deductions, you might save some money in taxes over the life of the loan by taking a deduction on the mortgage payment you’re paying. That deduction isn’t going to save you $100k, though. Paying $1500/month on an $1100/month loan will.
Of course, there’s an opportunity cost to paying more on your mortgage. You could be taking that money and investing it. Let’s say you put it somewhere safe, like a cd. At current interest rates, you could make as much as, let’s say 3.5%. If you invest an extra payment (1,135.83) per year for 30 years, compounding the interest at that rate, you’d earn $60,686.80 by the time you were done paying your mortgage. Of course, you’d have to pay taxes on the interest you earned on the money. One problem with this approach, is that most people won’t do it. Most people won’t consciously invest more just because they aren’t paying more towards their mortgage. Of course, you can have the best of both worlds in some respects if you want to, by following the first suggestion and making bi-weekly mortgage payments AND investing the extra payment per year for the next 30 years. That will save you $40k and make you $60k. That’s a big swing for one extra payment per year. You might also think about throwing a little extra at your mortgage now and then. Good luck, and thanks for reading.
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#1 by fern on August 10th, 2009 - 4:09 pm
I have a 30-year mortgage which i’m on track to pay off in 20 years. I can see the finish line, 6 more years to go. I’ve been prepaying right form the start, though in varying amounts and with a few hiatuses due to job loss.
There was a time i was just prepaying by about $100 a month; for the past few years i’ve been prepaying by $425 extra.
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Todd Metheny Reply:
August 10th, 2009 at 10:21 pm
Hi Fern, That’s great! Just imagine how much extra money you’ll have to invest once your mortgage is all the way paid off! Do you have a plan for what you’re going to do with all those extra payments when you’re done? I’d love to hear it. Good luck.
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#2 by Chessiq on August 10th, 2009 - 8:05 pm
Todd, good work explaining the effect/impact/options of so many things you can do right when you have a mortgage!
Just to add, I was reading a book called “Wealth Without Risk” by Charles J. Givens, a couple of months ago.
One idea I got from the book, which I thought was pretty neat, was on how to make an extra payment, that is not as big as a full payment… so, here it goes:
Let’s say your monthly payment is $1,200 and on your first payment, $1199 goes to interest while $1 goes to principal. On your second payment,$1198.95 goes to interest while $1.05 goes to principal, etc. When you are making your first payment, you should pay $1201 which covers the principal on the first and second month. On your second payment, you should pay the principal that covers that month and the following month, and so on and so forth. This way, you can pay off your mortgage in half the time(?!) I wonder if he said you should do that every month or every other month. I would need to look at a spreadsheet
Now I am thinking, if you calculated how much principal you pay during the first year, you can just pay add that amount to your payment for year, and then work on the second year, and third year… since amount applied to principal at the beginning is so little, you can shave off lots of years that way. Does it make sense?
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Todd Metheny Reply:
August 10th, 2009 at 10:30 pm
Would that work out to half the time? I’d have to see it on the spreadsheet, too. I guess it makes sense, logically, that if you always paid double the principal payment, you could pay it off in half the time – near the end, when it’s mostly principal, you’d have to be able to make a very large payment to pay double the principal though, wouldn’t you? I’m just thinking out loud (err, or on paper, err internet text;))
I haven’t heard of the book, is it a good one? It’s a good title. Is there such a thing as wealth without risk? Let me know what you think of the book (though I’m way behind – I have books that have been waiting for a long time to be read).
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#3 by MIchael on August 10th, 2009 - 9:54 pm
Really helpful, thanks.
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Todd Metheny Reply:
August 10th, 2009 at 11:02 pm
No problem. Glad I posted something useful;)
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