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 $300,000 mortgage (borrowed at 4.5%). 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 mailing the bank just one extra mortgage payment per year ($1500), they could save over $40,000 in interest and pay off the loan about four 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?
Making Saving Interesting
Most people’s brains are not wired to figure anything beyond basic math which makes compound interest calculations seems so incredible. 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 $1,500 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 is over $5,000! On the other hand, the savings on the 29th extra payment, which only saves them one year of interest, is worth just $67. While it’s possible to save money and have a paid off house sooner by making extra mortgage payments, whether it’s a smart financial move is harder to answer.
Pros and Cons: Less Debt With No Nest Egg
The main thing driving the Zabrowski’s to pay off their mortgage as soon as possible is the saving of 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, the money borrowed can also be invested profitably, and if the investment rate of return earned is higher than the cost of interest, the loan is a financial positive. Consider that the Zabrowskis are saving 4.5% on the annual extra $1,500 paid back to the bank. If instead, they’d invest that money into a mutual fund earning 7%, their earnings over the life of the mortgage would about $65,000, far more than the $40,00 in interest saved. If they can earn just 4.5% (and due to tax savings on mortgage debt, even a lot less), they do just as well from a financial perspective by saving and investing the extra payment money instead of sending it back to the bank.
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. 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 very long time frame as families grow, careers shift, and wedding expenses loom. 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 house equity.
Figuring What Works For You
Good financial advisors realize don’t treat people like robots: the best financial strategy is the one that works for their client’s habits, lifestyles, and preferences. While on a purely numbers basis, the Zabrowski’s 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 need incentives to save and barriers to spending. If the goal of mortgage payoff excites them and the encouragement of paying less interest is what it takes to get the Zabrowski’s to keep skimming off those dollars, then they should take advantage of that motivation. It’s a lot harder to take money out of home equity than it is 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: 3 Tips For Early Mortgage Payoff
If you do want to make extra mortgage payments: 1. Check with your mortgage company; most, but not of them, 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 (aka scammers) 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 🙂 .