Mortgage Prepayment: Money in the Bank

 

Editor’s note: This is an update of an article originally posted in May 2012 – our first week of publication. Since most of you missed it, we thought you might enjoy it.

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Mortgage Prepayment: Money in the BankThe 30-year mortgage is one of the biggest financial traps out there. There, I said it out loud.  Now, let me be clear by saying it again: the 30-year mortgage is one of the biggest financial traps out there!  While a 30-year mortgage may seem like a good idea, spending 30 years to pay it off could be one of the biggest financial mistakes of your life.

Before you get all bent out of shape and tell me why I’m wrong, I ask you to please hear me out.  First, we have a home mortgage.  In fact, we have three mortgages – one for our primary residence and one each for our two rental houses.  Without these loans, we would not have been able to afford these properties.  So, yes mortgages can be useful tools when they are used correctly.  Admittedly, we probably could not afford the houses we bought when we bought them.  That was our mistake.  However, it has always been our plan to pay these debts off early.  Our philosophy is that we will never let the bank make more money off of us than necessary.

What I am about to tell you is probably the best financial advice you will ever get.  If you do this, you will free yourself from the bonds of debt slavery much quicker than if you choose another path.  It goes against conventional wisdom and probably against the advice of nearly any professional financial advisor out there. However, it could be the key to your financial freedom.  Are you ready for this magical bit of advice?  Here it comes: pay your mortgage off early.

Mortgage Prepayment Basics

In order to pay-off your mortgage early, you will have to pay over and above your monthly payment.  So, if your payment is $1,000/month, you would need to pay more than $1,000/month to your mortgage company.  Provided that there are no prepayment penalties, I would argue that this is a great use of your resources.  The extra money should go directly to your principle balance, decreasing both your principle balance and the amount of interest that you owe.  Keep in mind that the amount of interest that you pay over the lifetime of the loan is front loaded, meaning that for the first 15 years or so on a 30-year mortgage, you are paying more interest than principal.  The faster you can knock down that principal balance, the less interest you will be paying the bank – which could save you tens of thousands of dollars during the life of the loan.  On a $200,000 loan at 6% interest, just $50/month extra can eliminate 3 years on your loan!  Now, that is saving money!

Professional financial advisors would almost never give you this sort of advice.  They would argue that you can make more money by investing it in some form of securities.  Their typical simple mathematical reasoning for this usually goes as follows:

Your mortgage interest rate is costing you approximately 4% interest on your investment.  However, over time, the stock market gives you a rate of return somewhere around 10%.  Therefore, if you invest the extra money you have, you would earn 6% more than you would by paying off your mortgage early.

That sounds like a pretty good argument, right?  Wrong.  While I think that most financial advisors are good people and are genuinely trying to help you make solid financial choices, the simple fact is that their math is wrong.  They are neglecting to include three things in their equation – taxes, fees, and risk.  You see, you have to pay a capital gains tax on any money earned through an investment.  That tax rate is currently 15%, but could either increase or decrease at any moment.  Also, each time you invest – make a purchase – through an advisor, there are fairly substantial fees and commissions that you must pay.  These vary from company to company, but they all have them.  Finally, there is no guarantee that you will make any money on your investment.  If you are able to pay off your house in a short amount of time, say 5 to 10 years, chances are very good that you will not actually reach a 10% return on your investment.  So, by they time you weigh all of these things into consideration, it is my belief that by investing your money, the results will be close to a wash. However, you will have taken on several more years of putting your house at risk.

Think about it this for a minute.  Who does paying off your house benefit besides you?  Nobody.  That is why most people in the financial field won’t give this advice to you.  Nobody makes any money in this endeavor but you.  The bank makes less money in interest, brokers and financial advisors make less in fees, and you get to keep more of your hard-earned money.  That is great for you, but bad for them.

Live Below Your “Means”

One of the big trends today is moving into a bigger “better” house as your income increases.  Lot’s of people will tell you that you can afford this upgrade in lifestyle, that you have the credit to get that $400,000 mortgage that you want.  I’m here to tell you that advice is bunk.  It is terrible.  Why trade one mortgage for another? Why start a new 30-year mortgage at age 40 and become a debt slave to the banks until you turn 70?  That doesn’t sound lilke good advice to me.

Of course, prepaying your mortgage is only a good idea if you have no other debt besides the mortgage.  If you have credit card balances, car loans, etc., then it is definitely best to pay those off first.  Additionally, you should only be prepaying your mortgage if you are also able to save for retirement.  If you have a work sponsored 401K or IRA, you should definitely be contributing as much are you are comfortably able to.  If you do not have a retirement plan sponsored through your employer or are self-employed, you should set up your own IRA.

So, if you want to live the rest of your life being a slave to debt, go ahead and pay those minimum payments on your mortgage.  If you want to have a starter castle that will take 30 years or more to pay off, go right ahead.   If you want to have as much home as you can manage to get financing for, by all means go for it.  But first, take a minute and imagine a different future for yourself.  Look ahead five or ten years and imagine owning your home outright.  Imagine what you could do, where you could go, and who you could be if you were not a slave to your mortgage.

If you don’t trust my advice, my challenge is this:  Find a person who has paid off their home early and ask them if they regret it.  Find one person, anyone, who wishes they hadn’t paid off their home ahead of schedule and I will eat my words.  Trust me, you won’t find this person.  They don’t exist.

About Greg

Greg Johnson is a proud husband, father, and debt crusader who believes in living life now while saving for the future. He is the co-founder of the personal finance website Club Thrifty, where he brings the awesome sauce each and every day.

Comments

  1. The realization of the fact that paying off your mortgage benefits no one but yourself invalidates the entire investment/financial advising mafia!

  2. I look at it this way – we pay slightly higher mortgage rates that they would otherwise be if we had pre-payment penalties… Knowing that the bank *wants* us to stay in the loan as long as possible makes you stop and wonder – who is benefitting more from this arrangement?

  3. Isn’t there an advantage to having a long term mortgage as well? For us we chose the 30yr mortgage option to give us a little more wiggle room to pay (other) debt off first. In 5 or so years when a huge chunk of the other debt is paid off we’ll re-allocate to extra mortgage payments. So although we have a 30yr term we have no intention of actually being in the term for 30 years but like having the option of only paying that monthly minimum. I know mortgage terms are different b/w canada/us and each bank but we’re allowed an anniversary payment every year, penalty free which is a decent chunk of money. Starting next year when I go back to work I will be setting aside money every month to do this to start then bump it up to a certain percentage ( I think 10% is allowed penalty free every year).

    • Sure, I think it depends on the individual person. If we had other debts, we would pay them off first. But we don’t so we are choosing to tackle our mortgage at this point!

  4. Nice post. It’s amazing what a little bit of extra money will do to knock down your mortgage. We typically try to make the equivalent of two extra monthly payments each year to knock it down. The interest savings is definitely worth it.

  5. I made the mistake of buying my first house with a 30 year mortgage and I regret it. The second house we bought, if we couldn’t afford the payments based on a 15 year mortgage, we didn’t buy it.

  6. In Canada, we aren’t allowed to take out 30 year mortgages any more – the max amortization is 25 years. Which I’m cool with. We have already discussed it and plan to pay down our mortgage quicker anyway. When we get one. But that $400K figure you threw out made me giggle. That’s a shack here!

  7. We have just over 9 years left on our primary mortgage, and can’t wait to knock it out. Our last refinance was on a 13 year term and we’re putting down extra to make it under 10 years. Our rental is at a 30 year term, just to help in the beginning, but we intend on paying that one off well before 30 years. I can tell you what can happen if you go into your 60’s with a mortgage like my inlaws who hit some hard times and actually lost their home to foreclosure. Not a place you want to go for sure.

  8. I did the thing where I reposted a lot of the pieces I wrote my first few weeks of blogging. This is great advice, and I think paying off real estate is always good advice.

    People should think about if they lost their jobs or became disabled and couldn’t work. Not having to worry about the house would be the ultimate insurance policy, wouldn’t it?

  9. I completely agree about paying off your mortgage early. A lot of people use the excuse that they’re getting the tax write off so they keep remortgaging their future. However, they don’t figure that if they’re in the 30% tax bracket and paid $10,000 in interest they’re paying the bank $7,000 to allow them to not pay the government the 3,000.

  10. We would like to get rid of our mortgage but we aren’t rushing it. There are many other areas we want to save and invest in which will in the long term provide us with more benefit. We will hopefully start making a dent soon though.

  11. Your point is well taken that paying off a mortgage is a good goal, but I would like to suggest another way to go about it.

    To me, paying extra money each month to pay down a mortgage is like rolling a boulder up a hill. It’s too much like work.

    Instead of using “active income,” like wages, to pay off debt, it’s a lot less painful to use “passive income.”

    I believe that the more efficient way to pay off your mortgage is to use the appreciated equity in a property. What I suggest is to buy an extra house, rent it out for several years, and finally refinance or sell it. Then, use the equity from your second house (or it could be a third or a fourth house) to pay off the mortgage on the first house.

    For example, if you put an extra $200 a month into the principal of your house, how long will it take to pay off the loan?

    Answer: A lot longer than selling an appreciated property and using the cash to retire debt.

    • I don’t think that anyone can plan on a rental property or their own home appreciating in any amount over the next 5-10 years. We do have two rental properties but we are keeping them for the long term to provide passive income when they are paid off in 14 years. Plus, having rental property is waaaaayyy more challenging than prepaying my mortgage. Prepaying requires very little work on my part.

      My house will be paid off in 35 months. I will be 35 years old. There is nothing that sounds like a better deal to me than to be debt free with a dual income household in my mid 30’s!

    • I completely agree with Holly here… Renting property out is challenging to say the least… Bank Rates are unpredictable in the long term and as Holly mentioned, appreciation is unlikely. Overpayments are a very safe approach and will have a huge reward!

  12. Great post!

    I have been looking at houses and realize unless we have a bigger down payment, we can barely afford the 15 year rate. We have to save more for the down payment so that we can get an affordable 15 year rate.

  13. We got a 30 year mortgage on our rental condo. It works out because we have someone paying the mortgage and mortgage interest and it keeps the monthly minimum payment low if we ever had a vacancy. We took a 25 year mortgage on the latest condo we bought. We could afford to take a shorter term, but we’re focusing on paying off the student loan first. :)

  14. We are firmly in the pay it off fast camp! 35 years were even worse! Once, we wanted to free up some cash flow quickly and due to our massive over payment, we could have dropped the payments down to less than half of the original amount! The flexibility of that, should anything ever happen, is amazing and very good to know. I want to have our absolutely required monthly payments to be as low as possible, so that we can survive on close to minimum wage, should the proverbial poop ever hit the fan.

  15. Tackling Our Debt says:

    I find it interesting at how different things are between Canada and the US even though we are right next door to each other.
    In Canada our homes will definitely increase in price over the next 5 to 10 years, so a person would accumulate a lot of equity in real estate. As well our current mortgage rates sit at approx 3.8%. In regard to fees and commissions for investments, I understand that could happen in some cases, but there are many investment options that do not have fees associated with them and still offer a good ROI.

    • It is very strange how much real estate prices vary across the country and in Canada. I have a nice house and for what paid for it you probably couldn’t even get anything in Canada.

  16. Although I have written a couple of similar posts, it never fails to amaze me that really small increases in repayments can knock significant time of the mortgage period!

  17. Your reasoning is strong but at 2.29% I am not in a hurry to repay my 30 years mortgage early. I invest most of the money and I know there is risk and tax and so on but thanks to not repaying I was able to buy a second property. It really depends what you do with the extra money, and if you want to have that weight lifted off your shoulders quickly.

  18. I really liked this! My boyfriend’s parents had paid off their mortgage early and when they renovated their second home, they took out a 15 year mortgage, which they are already planning to pay off in 12 years or less. It’s very motivating and I definitely don’t want a “starter castle” that I am a slave to for 30 years!

    • Having no house payment is very appealing! Think of everything you can do if you aren’t sending thousands of dollars in house payments out each month!

  19. I agree that 30 year fixed are a waste of money, primarily b/c rates are higher than they should be. I really don’t see inflation lifting rates by more than 1% for a loooong, loooong time!

  20. I really can’t imagine myself still paying our mortgage even at the age of retirement! We’ve only taken the 30 year mortgage to give us some time in paying it off but we won’t let it reach 30 years since we’re paying double every month.

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