Posted about 1 month ago

You Are Not Married to Your Mortgage

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You’re not married to your mortgage, and in this post, I’ll show you how to cheat on your bank.

A common misconception is that once you take out a 15 or 30-year mortgage, you’re stuck with it unless you refinance. But that’s actually not the case. Most residential mortgages today carry no prepayment penalties. And even if your home loan came with a prepayment penalty, new federal regulations limit those penalties to just the first three years of the loan.

What does that mean for the average homeowner? Well, it means that you don’t have to be stuck with your 30-year mortgage for 30 years. In fact, with some advance planning, you can years off the life of your loan. And the best part is, it usually doesn’t take a dramatic financial shift to do that.

To explain this idea, let’s look at a simple example:

John Smith buys a $500,000 home and puts 20% down. He then gets a 30-year conventional mortgage on the remaining amount of $400,000 at a 4% interest rate His monthly mortgage payment will be $1,910 (just principal and interest, excluding home insurance and property taxes). He’ll pay $22,916 annually for 30 years.

Let’s take the annual payment amount and multiply it by 30. We get $687,480. Wait a minute! If the loan amount was $400,000, why is the sum of all the payments to the bank 72% higher than the original amount? Interest, of course. The difference of $287,480 is the total interest paid to the bank on this 30-year loan.

And in this example, I’m looking at recent market rates for mortgages, which are near record lows. If you took out a mortgage when rates were higher, this differential would be even greater. For example, if you locked in a rate of 5% in the recent past, you will have paid $773,023 over 30 years on a $400,000 mortgage, or almost double the original loan amount!

Note: If you’d like to crunch your own numbers, check out this simple mortgage calculator (just make sure to zero out taxes, HOA, and insurance fields):

This is how banks make money on mortgages. If there was no money to be made, it would be much harder for the average American to get a loan to buy a house.

But what if we could “hack” the system? 

What if we could take out a 30-year loan and pay it off sooner and pay less in total interest? Actually, we can! That’s where prepayment comes into play.

Using our $400,000 loan, 4% interest rate, 30-year mortgage example above, let’s see what happens if we just made an extra $100 payment on our mortgage every month ($2,010 instead of $1,910):

With just a small increase of $100 a month, we would save $29,801 on total interest paid to the bank over the life of the loan. And we will have paid off the loan 2 years and 8 months sooner than the 30-year timeline. Not bad!

Now, let’s see what happens if we looked at our spending habits, trimmed some expense fat, cancelled some unused subscriptions, packed lunches from home a couple of times a week and allocated an extra $250 a month towards prepaying our mortgage (so that would be $1,910+$250):

In this scenario, we will have saved about $64,000 in total interest paid and shortened the loan by nearly 6 years (or 20% of the loan’s life)! Not too shabby.

If you really hate debt (and a home is almost always the biggest source of debt for the average American household), you can get even more aggressive with your paydown plans. If you were to bump up the extra payment to $500 a month, you’d shave $104,000 off the total interest paid and shorten the loan’s life by 9 years and 9 months (or 33% of the loan’s life).

Note: I highly recommend Dave Ramsey’s Mortgage Payoff Calculator, which you can find here:

“Max, this all sounds great, but I don’t have an extra $100 a month to pay down my mortgage faster, let alone $500.”

To be perfectly honest, as of this writing, I don’t have an extra $500 a month lying around either. But I will challenge anyone reading this about their alleged inability to come up with an extra $100 a month. Unless you’re a single mom or dad with two minimum wage jobs and 3 kids to take care of, you probably can find an extra $100 a month if you took the time to analyze your budget. For example, taking one fewer trips to Starbucks each workday (assuming you spend an average of $5 per visit) would save you $100 a month. I’m not picking on Starbucks, and I love coffee myself, I’m just giving you one example. Perhaps you can finally cut the cord on that overpriced cable TV subscription, with hundreds of channels you never watch. That’s another $100 right there.

If you’re not able or willing to do that, let me give you a couple of easier, almost imperceptible tweaks:

  1. 1.  Round up your monthly payment. Say your monthly mortgage payment (again, excluding insurance and taxes) is $1,850. Rounding it up to $1,900 will still save you a respectable $15,772 in total interest paid and cut a year and 5 months off the life of the loan.

  2. 2.  Pay every two weeks instead of once a month. Instead of making a payment of $1,910 (going back to my previous example), you could make a payment of $955 every two weeks. This simple change would save you a whopping $45,107 in total interest paid!
  3. If you want to see what difference bi-weekly payments would make for your loan, click here:

Now, I know what some of you skeptics are thinking: 

“But Max, what about the mortgage interest deduction? Why would I want to pay down my loan faster and lose that great tax deduction?” 

While it is a great tax deduction that has encouraged home ownership for a very long time, most people don’t actually need to use it. That’s because for most Americans, the standard deduction (especially after the Tax Cuts and Jobs Act nearly doubled it recently) is higher than what they could deduct if they itemized their tax deductions. For example, for the 2019 filing year, a single person can take a standard deduction of $12,200, while a married couple filing jointly can take a standard deduction of $24,400.

If you bought a $500,000 home, while borrowing $400,000, the total interest you will have paid the first year would be $15,872. If you’re married, that’s significantly lower than the standard deduction you’d be entitled to. And if you took out a mortgage a while ago (assuming a similar loan amount), your total annual interest payments are probably significantly lower, due to the fact that over time, more of our monthly payments go towards principal paydown and less towards interest (just google “mortgage amortization table” if you’re not sure what I’m referring to), so the mortgage interest deduction would make even less sense for you.

OK, now that we got that out of the way, I want to focus on one more topic. So far, we’ve discussed why and how you can pay down your mortgage faster. But when should you NOT think about prepaying your mortgage?

First, you should absolutely not think about prepaying your mortgage if you’re carrying forward high-interest credit card balances every month. Most credit cards have APRs of nearly 20% (some are even higher, depending on your FICO score and the specific credit card product). If you’re racking up credit card debt and not paying off the balance in full each month, then you’re wasting a lot of money on interest payments, while bolstering the profits of the bank that issued that credit card. Your first financial priority should be to put together a plan to pay off that high-interest debt, especially if you’re only making minimum payments, since most of that goes towards the interest portion of your debt.

Second, if you still have student loan debt that you’re only making minimum payments on, and the interest rate on those loans is higher than your fixed mortgage rate, you should focus on paying down those loans before thinking about prepaying your mortgage.

In other words, if you took out a bunch of loans years ago, and their current interest rates range from 5% to 8%, while your mortgage rate is 4.5%, you should focus on paying down the higher-interest student loan debt first. Start by putting together a summary of all of your outstanding student loans, balances, and interest rates, then create a plan for paying them down faster by making more than the minimum payments on the highest-interest loan first (while continuing to make minimum payments on the rest). Once you’ve paid down that loan, you can move on to the second highest-interest-rate loan and do the same for that one. Only when you’ve paid off any student loans with a higher interest rate than your mortgage rate should you think about prepaying your mortgage.

Third, if you’re not maximizing your tax-deferred retirement savings, you should allocate funds to that wealth-building strategy rather than paying down your mortgage. That’s especially true if you have a company-sponsored 401k plan that you are either not contributing to or not contributing enough to get the maximum company match.

If that’s the case, you’re missing out on free money. Most corporations offer a dollar-for-dollar match on employee contributions, up to a certain limit, usually capped by a percentage of your annual gross income. Let’s say that limit is $5,000 a year. That means that if you contribute $5,000 a year to your 401k plan, your employer will add another $5,000. Not only are you getting $5,000 for no additional work, but both your contributions and your employer’s match are tax-deferred, so the invested funds can grow tax-free until you reach retirement age and start withdrawing from your 401k account. If you’re not taking advantage of this and the tremendous power of tax-deferred compounding, you should change that quickly!

On a related note, you should also try to contribute the maximum allowable amount every year to your IRA (Individual Retirement Account). This is another tax-deterred way to build wealth for your retirement, while enjoying a nice tax write-off every year for your annual IRA contribution (IRS deducts it from your gross reported income, which reduces your tax burden). If you hypothetically invest those funds in a low-cost S&P 500 index fund (a passive fund that tracks the performance of the 500 largest publicly traded companies in the US), you can enjoy average annual returns of between 7% and 9%, with the benefit of tax-deferred compounding for decades (assuming you’re not already approaching retirement age).

The 2019 annual IRA contribution limit is $6,000 per individual under age 50. If you don’t have an IRA already, it’s very easy to set one up with companies like Fidelity.

Finally, you shouldn’t focus on paying down your mortgage until you’ve set up an emergency fund for unforeseen expenses, such as a medical emergency or an expensive home repair (like fixing a leaking roof or replacing a busted boiler). There is no “ideal” emergency fund amount, since that is a very individual choice, driven by your lifestyle, savings rate, and risk tolerance. The point is, you should have a reserve account for unexpected expenses, because as Forest Gump sagely stated: “’It’ happens.”

In closing, I hope that after reading this post, you will take a fresh look at your biggest sources of debt, which if you’re a homeowner like me, is probably your outstanding mortgage balance, and think about smart ways to cut months or years off the life of that loan, while saving thousands of dollars in total interest paid.

And while you’re at it, create a spreadsheet of all your outstanding debt, including your student loans, credit card debt, and any other forms of debt you may have hanging over your head. List the balances, interest rates, and whether they are fixed or floating, then decide what debt you should tackle first (hint: the highest interest one!).

Paying down debt doesn’t just improve your personal balance sheet and wealth-building prospects, it also reduces stress and provides more financial flexibility in the future.

Don’t worry – you got this!

Comments (7)

  1. I'm not convinced this is as rosy as it sounds, particularly when the alternative is earning a greater return in an index fund than you're paying on the mortgage.  So I'll throw a bunch of math out here and leave it to the masses to point out the flaws in my logic:   

    An extra $100/month = $1200/year x 27 years (two years, eight months knocked off the mortgage) costs $32,800 to save $29,801 on interest over the life of the loan.  Additional saving of $1910 x 32 (fewer payments) = $61,120.  Total savings:  $90,921.

    Investing $100/month for 27 years at 7% (compounded annually) = $89,381.  Kind of wash...  9% - $123,268.  

    $250/month for 24+ years is $72,000+ out of pocket to save $64,000 interest + $137,520 (72 fewer payments) = $201,520 total savings.

    $250/month invested for 24 years at 7% = $174,530.  9% - $230,369.  What kind of return do you think your index fund will fetch?

    $500/month for 20 years is $120,000 out of pocket to save $104,000 interest + $223,470 (117 fewer payments) = $327,470 total savings.

    $500/month invested for 20 years at 7% = $245,973.  9% - $306,961.  Maybe now pay down the principal aggressively?  But...

    1.  The numbers change (more) in favor of not paying down the principal if you already have some money in the index fund when you make your first house payment.  The greater your initial balance, the greater the case for not making the extra principal payments.

    2.  Consider starting from scratch if you were going to live in the house for 30 years under each scenario and making 30 years of equal payments toward either your house or index fund.

    No extra payments - house paid in 30 years, $0 in index fund.

    $100 extra monthly payment (360 payments of $2,010) - house paid off in 27.33 years, $2,010/month x 32 months (7%) = roughly $84,000 in the fund + paid off house at 30 years.  Just investing $100/month for 30 years (7%) and making your regular payments would yield about $113,000 in the fund; you'd still have the house paid off.

    $250 extra monthly payment (360 payments of $2,160) - house paid off in 24 years, $2,160 x 72 months = roughly $185,000 in the fund + paid off house at 30 years.  $250/month for 30 years is about $283,000 and a paid off house.

    $500 extra monthly payment (360 payments of $2,410) - house paid off in 20.25 years, $2,410 x 117 months = roughly $386,000 + paid off house at 30 years.  $500/month for 30 years is about $567,000 and a paid off house.

    The fund numbers all look even more attractive at 9% interest.  If the options to consider are paying your principal down or putting that money in an index fund, I think the sooner you can start building your fund, the better off you'll be (see 1. above - that applies to starting index fund contributions once your house is paid off too).  I don't see the argument for paying off borrowed 4% money when you know the alternative is earning more than that over a 30 year period in any other investment.  

    What am I missing?

  2. I use a program that shows me, in real time, exactly where and how to move money to eliminate the maximum amount of interest on my mortgage and any other debts. 

    It doesn't require that I make extra payments or change my budget and I have gone from paying off all debts (mortgage included) in 38.5 years down to 8.7 years. 

    The difference between what banks want you to do and what is very easily possible is ridiculous.

    1. Haven M.

      What plan are you using that doesn't require you to make extra payments or change your budget to go from 38.5 years to 8.7? 

      Cora C

  3. It was masterful the way that you explained all of this information. I try and explain this to buyers all of the time, and many don't grasp how this is possible. I appreciate the great information! Thanks Aaron

    1. Thank you, Aaron!  I appreciate you reading my post and for taking the time to provide such positive feedback.  Sometimes, it just takes someone reading about a concept and seeing the numbers to grasp it. 

  4. It was masterful the way that you explained all of this information. I try and explain this to buyers all of the time, and many don't grasp how this is possible. I appreciate the great information! Thanks Aaron