“To reach a port we must set sail –
Sail, not tie at anchor
Sail, not drift.”
― Franklin D. Roosevelt

We made the decision of paying off our mortgage before we retire. We make extra payments towards our mortgage to achieve this. But is this a good move?

Strictly speaking, you are better off not paying anything more than you have to, towards your mortgage (or any other low interest loan). If you have the discipline to invest that money, that is!

Mortgage rates are usually lower than what you would make on the stock market. When you also factor in inflation, buying power of the same amount would be much less later.

However, paying off the mortgage even by a small amount is going to shave a lot of time off the entire time period. This is because of the way the loan is structured so that you make equal payments all along your loan period. Towards the beginning of your journey, this results in most of your payments just going towards the interest. The principal doesn’t come down by a lot.

When we got our mortgage three years back, we got one with a fixed rate for five years. Since we have only about two years left to get to that point, I decided to go through the mortgage documents to make sure that there is going to be no surprises later on. I noticed that the set of documents also included a few sheets of paper that had a table describing how much went towards principal and interest each month.

Case study: $205,100 loan at 3.96% interest, 30 year fixed mortgage.

I have a schedule here, for an imaginary loan of $205,100 (the median home value in the US right now, according to Zillow) at 3.96% interest rate (current rate for 30 year fixed mortgage according to mortgagecalculator.org). The loan amortization template was from Microsoft, and it came along with the installation of Microsoft Excel.

The figure above only shows the payments for the first year. If you look at the first payment (of $974.45) , only $297.62 of it goes towards the principal. And you pay $676.83 towards the interest. Suppose, at that point you could afford to pay the second month’s principal($298.61) as well. This will bring the total payment upto $1,273.06, which is the sum of  $974.45 and $298.61. By paying that extra $298.61, you would progress an extra month on your mortgage payment schedule.

On the top right corner of that table, I have the total interest and principal that you would pay in the first month. The total principal paid off is $3,637.04 and the interest is $8,056.42. If you can pay $3,637.04 ahead of time, you can save $8,056.42 over the course of the loan period. It will also cut your loan period by a year.

Your case may be different!

Of course, the exact amounts would depend on your mortgage amount, rate of interest, and how far along you are. If you are almost at the end of your mortgage period, most of your payment goes towards your principal. It won’t make a dramatic change at that point.

What did we do?

While we were buying our home, I turned to the internet to read more about mortgages. I did see several articles talking about taking a 15 year mortgage instead of a 30 year mortgage. Several others talked about making half the payments every two weeks instead of every month because there are 26 periods of two weeks each year, where as there are only 24 half months. All of that makes sense.

What I did not see anywhere was calculations that showed how contributing even small amounts could change the course of your mortgage.

We opted for a 30 year plan to keep the payments low. We wanted to make sure that we could pay them even if we lost one job, etc. Plus that brought the value of our emergency stash down. However, we made sure that there were no prepayment penalties. We have paid more than what was strictly necessary every single month so far. Some months, the extra payments are really low. Some months, they are substantial.

So if all you can afford is a 30 year mortgage, go ahead and take that. You do not have to push yourself to get a 15 year plan. You may get a lower interest rate on the 15 year mortgage. If you think that is something you can pay every month, getting a 15 year mortgage is better than the 30 year mortgage (especially if you get it at a lower interest rate). However, if it is more manageable to get at 30 year mortgage, do that. And pay off everything you can afford to. Just make sure that there is no prepayment penalty, like we did!

Limitations

The calculations here have been simplified. I do not take into account the effect of PMI if you have any. However, you would get to eliminate the PMI earlier if you do this. That will potentially save you hundreds of dollars extra. We did exactly that.

Paying the loan off early will also not get you out of the home insurance and property taxes (if they are collected together with your mortgage payment). If you are further along the mortgage, your mileage will vary. However, whatever stage you are at right now, paying off part of the principal could help you shave off days, if not months or years, of the entire mortgage period.

By the way, we are now paying towards the principal what we would have paid in 2030 had we followed their plan. We have saved a lot in interest already. If everything goes according to plan, we will have paid off the entire thing in another 1937 days. I update the remaining mortgage amount every Monday on the top right of the blog posts.

Our decision to pay off the mortgage soon was made consciously. We do want to keep our total expenses low when we retire. We see mortgage as another expense that we need to eliminate to get to our spending goal. We do not, however, use all our savings to pay our mortgage off. We systematically invest a huge chunk of our savings in VTSAX every month.

Before you make a decision to pay extra towards your mortgage, please ensure that it makes sense to you. Once that amount is paid off, you cannot get it back easily. More likely than not, the better financial decision is to invest that amount.

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Friday, Dec 2, 2022