Pay Less Mortgage Interest
October 9th, 2008
Despite all the programs available to minimize your current mortgage, there is only one way to pay less mortgage interest: apply additional money toward principal. The bottom line is that you must reduce the principal loan balance if you want to reduce the associated interest … period.
As you know, the interest on a mortgage is front-end loaded. What this means is the bank receives the highest percentage interest on the largest balance in the beginning of the loan while it receives the lowest percentage interest on the smallest loan balance toward the end of the loan. The lending institutions capitalize on the fact that as a group homeowners tend to move or refinance every five years or so. The banks love this trend because they get to start the process of maximizing the interest they can charge us all over again and we rarely break out of this vicious cycle. Before we even begin to make a dent in our loan, we move or refinance.
I’m not sure how the lending institutions have been allowed to advertise an interest rate of say 6% when the real cost of borrowing money secured against your property is more … much more. If you look at an amortization schedule for a $200K loan at a 6% fixed rate for 30 years, you see that the monthly payment is $1199.10. Principal payment: $199.10. Interest payment: $1000. In month one of this loan, over 83% of the payment goes toward interest. It’s not until month 222 (18.5 years), that 50% the payment goes toward interest and 50% goes toward principal. It’s not until month 348 (29 years), that 6% of the payment goes toward interest. Is this mortgage really a 6% loan? Yes! Can you believe it? The total repayment for this loan is $431,677 … $231,677 in interest or 115% of the original loan. I’ll ask again … is this a 6% loan? Of course it is. It’s the way the interest is calculated. Remember what Einstein said: “The most powerful force in the universe is compound interest.”
Here are a few reasons to consider accelerating your mortgage payments …
1. Create more equity … faster -
As you pay down a mortgage, you extend the gap between what you owe on your mortgage and the potential value your home. As home values increase, your equity tends to expand with it. The opposite holds true in a down market. Your equity tends to shrink as home values decrease. In either market, we create more equity by pre-paying our mortgage.
Why create more equity? For me, it’s a combination of forced savings coupled with the option to increase my borrowing power. It’s an easy way to pay me first. As my primary mortgage balance decreases every $25K or so, there is a corresponding increase in my home equity line of credit. I don’t want to wait until I need that credit before applying for it. It may be too late. It’s kind of my safety net or insurance policy. Or, there may be an investment opportunity that requires liquid resources. I may need to write a check in a hurry. Did I mention what happens to your borrowing power when you own your home free and clear?
2. Upside down –
Let’s say you create extra equity by applying more money toward principal for a couple of years and the market goes down. That increased equity may save you from being upside down (when the value of your home is less than the mortgage balance) if you do have to sell at the bottom. Or, it may help you get right side up, so you can sell your home sooner with no out of pocket expense.
3. Zero risk investing -
There are two ways to raise your net worth: increase assets and/or decrease liabilities. It’s much easier to decrease your liabilities than it is to increase your assets. We take out the ‘middle-man’ when we decrease our liabilities. We go directly to the source and eliminate the debt. When we increase our assets through the stock market or any other investment, there is a ‘middle-man’. Somebody is going to get paid to increase your assets and, most importantly, there is risk. The main point I want to make is that there is some level of risk associated with increasing your assets. There is no, zero, zilch risk with decreasing your liabilities. You know exactly the return on investment going in. There is no guessing, hoping, or praying to achieve the desired outcome.
For example, let’s say in month two of our example that you decide to decrease your mortgage liability. You pay the normal $1199.10 plus an additional $2056.81 and apply it to principal only. This amount represents 10 additional payments toward principal. So, after two months you have made 12 months of payments. With this one extra chunk, you just eliminated $9934.19 of interest charges that you don’t have to pay the bank. This number represents the total corresponding interest charges associated with the 10 monthly principal payments that you just made with that extra payment. You invest $2056.81 and save $9934.19 over the life of the loan. There is truth in what you learned as a child: a penny saved is a penny earned. I’m not exactly sure what this translates to in terms of return on investment but it’s pretty close to 483%. Also, in month three, more of your payment will be applied toward principal.
4. Pride of ownership –
For those of you who have paid off your mortgage, how does it feel? There is a sense of satisfaction and pride to be in that select group of true homeowners … as opposed to mortgage owners. As far as I’m concerned, home ownership is similar to paying rent: the bank is your landlord for a long time. There are solutions available to you that resolve this challenge — even if you don’t think you have the resources to do so.
5. Stress relief –
Once that mortgage is paid off and you have continued to increase your lines of credit as was discussed earlier, the fear of job loss or illness doesn’t weigh so heavy. Your financial future is much brighter. Your health is much better.
6. Risk investing –
Once the mortgage is paid off, one can invest at a faster pace to achieve financial goals. Let’s do some basic math with no tax consequences.
Scenario #1:
Let’s assume that you pay this mortgage as scheduled and you invest $250 per month for 30 years achieving an overall 10% annualized rate of return. This pile would be worth $565,122 plus your home free and clear.
Scenario #2:
Let’s assume that you use the same $250 to accelerate your mortgage payoff down to 13 years. Now, let’s take that old mortgage payment of $1199.10 plus the $250 and invest it for 17 years in the same vehicle achieving annualized returns of 10%. This pile would be worth $771,302 plus your home free and clear. This is a difference of over $206K at the end of 30 years. Which pile do you prefer?
7. Eliminate Private Mortgage Insurance (PMI) –
Once that loan to value ratio drops below 80%, you can eliminate the monthly PMI. Other insurance costs associated with mortgages also go down as the balance decreases.
8. Tax deduction –
Once the mortgage is paid down to year 25 or so, there is a small or essentially no tax deduction. It’s comforting to know that I could borrow from my home equity line of credit and purchase something (rental property, boat, car…) with cash and get a tax deduction if I wanted it. On the other hand, I’m not one for paying a dollar so I can receive $0.30 in return on my taxes.
9. Personal circumstances dictate -
Yes, pay off credit cards and other high interest debt. Yes, continue to invest in the children’s college fund, insurance products, qualified plans, real estate or any other vehicle that involves risk if it feels right for you and your strategy limits exposure and reduces taxes upon retirement. I am a huge fan of equity investing … do not get me wrong. The strategy to pay less mortgage interest is just one part of a well-balanced plan to diversify your portfolio on your way to increased wealth.
There is a solution to Pay Less Mortgage Interest.