When it comes to finances, nothing makes me more excited than seeing a ton of money leave my bank account each month. I just can’t wait to enter it into my “House Payment Analysis” spreadsheet, to see the amount saved go up a few hundred dollars, and be one month closer to payoff. Why does this make me so happy? Well, a lot of it is because I love numbers, but also because we made a plan to own our home in just under 7 years, 76.9% faster than the 30 years the loan was signed for.
Forget the Tax Deduction
Some people say you shouldn’t pay off your house because there are so many tax benefits. While there could be strategy in focusing on debts without tax benefits first, not paying it off for tax reasons doesn’t make any sense. Yes, you won’t get a tax deduction for the interest you are paying, but that’s because you don’t have to pay it at all! Would you rather get $100, pay the bank $100, and have Uncle Sam give you back $20 he took from the other part of your paycheck? or would you rather get $100, keep $80 and give $20 to Uncle Sam without anything extra coming out of the remaining paycheck?
Saving/Investing vs. Paying Down your House
Other people are more comfortable saving their money instead of dropping it into their house. In the current state of things, I can get as high as 1% interest on my savings, maybe 2% if I have a lot to save and can stash it away for a long time in a certificate draft (CD). My mortgage rate is 4.625%. Despite it’s phenomenal performance from 1945 to 1995 even the S&P 500 isn’t set to beat that rate (currently returning about 4.4% or less). In other words, unless you are in a more specialized index, the interest you save on your house is probably your biggest gainer.
If you get a higher return out of savings or dividend stocks than you are paying on your house, and it fits within your risk tolerances, you might do better with a mortgage offset account. That is, pay the minimum on your home and put the excess you could have put on your house into the high return investment. The investment account will grow faster than your house would have paid down. Once you have enough money in the account to pay off your home, you can either withdraw it and become debt free, or keep it for a few more years and pay it off with some money to spare.
Close your Mortgage in Half the Time!
(For a LOT less Money)
So how am I paying it off so quickly? It turns out that just adding a little to your monthly payment can make a HUGE difference. Even $5/month extra will save a few thousand dollars and a few months over a 30 year loan. At the beginning of your loan, most of your payment goes towards all the interest you owe on the principal (the amount needing paid off), not reducing the amount you still owe. You'll just have to pay nearly all of that interest again next month and make you feel like you're running in place. Adding just a little straight to principal will give you much more bang for your buck.
Not sure how to find a few extra dollars? Stay tuned for more posts.
Make sure when you add the little extra that it is explicitly marked as towards the principal. Otherwise, it will likely go towards the next payment and not get any compounding effects.
Here’s my simplified formula to pay off your mortgage in half the time:
Because this ignores some funny exponential math, it isn’t exactly half the time, but pretty close. If your 30 year mortgage rate is over 4.6%, you’ll pay it off a little faster. If it less, it will take a little longer (but you'll be saving more money anyways). You’ll have to do your own math if you are in the middle of your loan or have a different length. Click here for my free fancy calculator so you can see what happens with YOUR numbers.
Your monthly payment has three components:
1. Principal = The principal is actually the amount of money you still owe on the house, but they make it confusing and reuse the term. The principal payment is the money that actually goes towards paying down the house (towards the actual principal).
2. Interest = The amount charged as interest on the remaining principal. It decreases as you have less money borrowed.
3. Escrow = This covers your home insurance and property taxes. The lender forces you to pay it to a special account to ensure they never get stuck with back taxes or an unfunded burnt down home. Even after you pay off your home, you will continue to pay these amounts, but directly to the insurance and government instead of escrow.
Your loan is worked out such that your monthly payments are constant despite the lowering interest. This is done by increasing the principal payment slowly over time. Principal payment plus Interest should equal a constant.
Here's the equation you've been waiting for. Just look to your statement to see what your numbers are:
Escrow + 1.5 x (Principal + Interest) = amount you need to pay each month to cut your loan length in half!
Alternative way of looking at it because words and math are hard to mix: Take any statement, add the principal and interest payments together, the divide that number in half. The result is the additional amount that you need to pay to principal each month.
Did you notice? You add less than 50% to your payment and it counts as two (200%) payments!
Alternative Double Principal Method
My father had a different approach which also cut the mortgage length in half. He would simply write another check for whatever the principal portion of each payment was and put it straight to principal. The advantages of this method is that the number you need is written right on your statement and it is relatively easy to implement at the beginning when the principal portion is so small. As the principal portion grows, theoretically so does your paycheck making it is okay that you'll be almost doubling your whole payment near the end.
You are going to be SO MUCH better off with this method in comparison to the straight 30 year loan, but I see 3 disadvantages to the Double Principal method in comparison to my half Principal + Interest method:
1. The beginning is when you have the greatest power to knock months off your loan and save money. You won't save quite as much money with the double principal method.
2. You might make more money as you go, but your lifestyle will grow too. I think we all know life only gets more and more expensive. In your future you'll probably add children, catch the travel bug, demand better kitchen appliances, get more picky about food, or otherwise increase your cost of living. Also, I wouldn't count on wages growing faster than inflation for the next decade. We are in a currency war and, in the words of Jim Rickards, "the only way to win a currency war is to stay out of it".
3. Maybe the most significant flaw in this method is you can't automate it. Every month you will have to look at the numbers and make a payment. Autopay won't work. As I learned from David Bach's book, The Automatic Millionaire, the key to growing wealthy over time is automation.
As life gets more expensive and your principal portion jumps up more and more rapidly, you will need a huge amount of discipline and capital to keep this method up. I don't trust myself that much.
Alternative 15 Year Plan
You could instead look into getting a 15 year loan from the get go. The advantage is that they usually have a lower interest rate and they force you to stick to your early payoff plan. This is a great idea if you need help sticking to the early pay off plan. The only problem is you also have to hope life won't throw you any dramatic curve balls in the next 15 years.
Worst case, you do have to drop down to a smaller payment and refinance to a 30 year loan. You'll have to pay closing costs, but those fees will likely be added to the principal so you don't need the cash on hand in your rainy day scenario. It will set you back, but hopefully you'll have enough years paying it off at a 15 year rate that it will make up for the loss.
I personally like the safety net of being able to go back to a low payment for rainy day purposes. This way, I can put the extra principal payments in the "investment" category of my spending tracker instead of "bills", effectively lowering my living costs.
Unless you can get a substantially lower interest rate and you are confident in your other rainy day funds, I’d just go with the full 30 years and cut it in half on your own. It won't cost much more.
The Home Improvement Pitfall
I have a friend who bought a home at the peak of the market. He and his wife are among the most intelligent people I know, so paying his house off early was a no-brainier for them. They set a plan to pay it off in 10 years despite the high price tag. They stuck with the plan for a while, but as time went on, they made some trade-offs. Instead of paying the extra towards their mortgage, they started paying it into the house with kitchen remodeling and various flooring.
10 years later, when they would have been all paid off, they moved. In that amount of time, the housing market had crashed and they were forced to sell for less than they still owed, even with the updated kitchen. Had they stuck with the plan, they would have come out of the transaction with the entire sale price (minus fees) as liquid money for a down payment on the next home.
Moral of the story: If you pay off your home, you can always sell it for something. Stick to your payoff plan and get there as fast as you can. You never know what the market or your life has in store for you. If the market just goes up, you can always do the projects later. It won’t hurt you to focus on payoff first.
Disclaimer: I am not a licensed or certified financial coach, planner or adviser, just an enthusiast. Anything I recommend should be personally analyzed and discussed with your financial adviser.