It was great to be in their own home finally, but Doniel and Rachel Zabrowski hated that they were now “partners” with a bank due to their new $600,000 mortgage (borrowed at 6.5%). Unless they did something about it, a large chunk of their income would be paid out to this mortgage lender for the next 30 years! Rachel’s sister had mentioned that by sending the bank just one extra mortgage payment per year ($3,800), they could save almost $170,000 in interest and pay off the loan about 6 years earlier!
The savings sounded very attractive to Doniel and Rachel. Every day, they tried to skimp on something and throw a few dollars in a jar so that they could save up for that additional mortgage payment.
Is making extra mortgage payments a smart financial move? Can such a small change indeed save homeowners so much money?
This Is Math, Not Magic
Most people’s brains are not wired to figure anything beyond basic math, which makes compound-interest calculations seem so incredible. (Here’s a link to a good mortgage payoff calculator.)
Compound interest is the reason why even just a few extra payments made early on can save the Zabrowski family a fortune over the life of the mortgage. When they send the bank $3,800 during the first year of a 30-year loan, they are saving 29 years’ worth of compound interest on it. The savings on that one payment alone are over $21,000! On the other hand, the savings on the 29th annual extra payment, which only saves them one year of interest, is worth just $247. While it’s definitely possible to save money and pay off a house sooner by making extra mortgage payments, determining whether it’s a smart financial move is more challenging.
Better Returns Available Elsewhere?
The main thing driving the Zabrowskis to pay off their mortgage as soon as possible is the savings on loan interest. Borrowers tend to focus on the negative side of a loan: they now need to make payments and pay interest to somebody. However, money borrowed and not yet repaid can also be invested profitably. If the investment rate of return earned is higher than the cost of interest, the loan is a financial positive.
Here’s the math. Consider that the Zabrowskis are saving 6.5% on the annual extra $3,800 paid back to the bank. If, instead, they invested that extra money in a mutual fund averaging 10%, they’d accumulate a nest egg worth $625,000, in addition to the paid-off house. (30 annual payments of $3,800 over 30 years @10%= $625,077.) This approach leaves them far better off than the early mortgage payoff approach. Although an early payoff would enable a large buildup of savings after mortgage payments stop, the accumulation would total $352,000 in addition to the paid-off house. (69 monthly payments @10% = $352,443.)
Now, admittedly, the 6.5% return/savings of paying down a mortgage is guaranteed, while mutual fund returns definitely aren’t. But in the very long run, i.e., the decades of a home mortgage, there’s a fair argument that the risk of something like the S&P 500 is minimal and worthwhile. It at least creates a financial toss-up, not the no-brainer approach some proponents of early mortgage payoff make it out to be.
Liquidity Is Valuable, Too
And even if investment funds will earn just 6.5%, on par with the mortgage interest (and due to foregone tax savings on mortgage debt, even a lot less), homeowners may be better off keeping and investing the extra payment money instead of sending it back to the bank. Why? Due to better liquidity and flexibility in maintaining some funds outside of your home equity.
A typical home mortgage takes 30 years to pay off. This period seems like forever to most people, and paying off their most significant financial burden earlier is very attractive to them. Indeed, it may feel like the prudent and sensible thing to do. But putting more money into mortgage payoff also means that less of it is available to the homeowners, many of whom have virtually all of their net worth tied up in their house.
What will happen if they need money during that extended time frame, as families grow, careers shift, and wedding expenses arise? Say 10 years into their mortgage, Doniel loses his job. Will the fact that their mortgage is due to be paid off in another 16 years, instead of 20, mean much at that point? And if 10 years after that crisis (with either 6 or 10 years left on the loan), they need money to marry off a daughter, how will the extra equity in their house help them cover it? At these points, they may wish they’d built up a pot of available money instead of locking it in as additional home equity.
Figuring What Works For You
Good financial advisors understand that you don’t treat people like robots: the best financial strategy is the one that works for their clients’ unique habits, lifestyles, and preferences. While on a purely numbers basis, the Zabrowskis can probably come out ahead by investing their savings instead of making additional mortgage payments, they need to be realistic about what makes sense for themselves.
Many people struggle to accumulate money and require incentives to save, as well as barriers to prevent excessive spending. There’s also a significant psychological and motivational value to eliminating the steady, heavy burden of mortgage payments as soon as possible.
If the goal of an early mortgage payoff excites them and the encouragement of paying less interest is what it takes to get the Zabrowskis to keep skimming off those dollars, then they should take advantage of that motivation. It’s a lot harder to withdraw money from home equity than from a mutual fund, so some families find that the best wealth-building strategy for them is paying off their mortgage as quickly as possible. Everyone else should save and then invest the rest.
Just By the Way: Three Tips for Early Mortgage Payoff
If you do want to make extra mortgage payments:
1. Check with your mortgage company; most, but not all, allow it.
2. When you send in the extra money, make sure the bank knows what it’s for. Otherwise, they may assume you’ve paid next month’s payment early (and not additional principal), saving you nothing.
3. Finally, this being America, there are companies (a.k.a. scams) offering to do various versions of the strategy explained in this article for you for a hefty fee. In essence, these people charge hundreds, or even thousands, of dollars for the service of taking your money and mailing it to your mortgage company. If you pay that kind of money for mailing out envelopes, please let me know. I’ll do it for half that price 🙂.
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