Should You Be Making Those Extra Mortgage Payments?

My family and I moved last week, and I am the proud owner of a brand new 30-year fixed mortgage loan.  At our closing, the person with the title agency showed me the amortization table and said, “Don’t be overwhelmed by the interest – that’s only if you don’t make extra payments.”  With a big smile I replied, “I plan to pay every cent of that interest and I’m thrilled about it.”  She laughed, assuming I was joking.  I just can’t help myself sometimes, so I launched right into it…

Would you prefer to have a lot of debt, or no debt?  Should you be making extra payments into your mortgage?  Believe it or not, those are two very different questions.  As we say with every decision, there is a financial answer and an emotional answer.

The emotional answer to the question, “should I put extra money into my mortgage” is typically yes.  Let’s face it:  debt doesn’t feel good.  No one likes to login to their bank app and see that they are hundreds of thousands of dollars in the hole.  We all fantasize about that last mortgage payment we will make and how good it will feel.  I’m no exception to that.

The financial answer here is not as simple.  If you take out a new 30-year mortgage today, it might be in the ballpark of 4.25% - 4.5%.  If you’re paying 4.25% on paper, you’re probably actually paying more like 3.5-3.75% if that interest is tax-deductible.  Finance and economics are all about opportunity costs.  Don’t just consider the 4.25% you are paying.  Maybe you could be earning 6% or 7% if you invested your excess funds instead.  The market return is no guarantee of course, but over a long period of time, the odds of netting greater than 3.5% rate of return may be reasonable to expect from a diversified portfolio.

Let’s think about one of the many ways banks make money.  You give money to your bank and what do they do?  They loan it to home buyers and small businesses.  They pay you that exorbitant .1% interest rate and they can earn 5, 6, 7% or more on the loans that they make.  If you have access to capital, patience, and a moderate risk tolerance, you can take advantage of leverage as well.  If a bank can borrow at 3.5% and earn 6% or 7% like you can, they would borrow as much as they could get their hands on.

If your only goal is to pay off your mortgage as fast as possible, what is the best way to do it?  Conventional wisdom says the more you pay into your mortgage, the faster you can pay it off.  Provided you can earn more in an investment account than your net cost of borrowing, you may be better off investing your excess cash each month, and then paying off the mortgage when the investment account balance surpasses the mortgage balance.

Are you adequately saving for retirement and college?  Do you have sufficient liquidity on hand for the unknown?  Generally speaking, accelerating your mortgage payments only accomplishes one goal at the expense of many others.  There are many points to consider to determine which approach is right for you.  The following questions may help you decide which option makes the most sense:

• What is your mortgage interest rate? The lower the rate on the mortgage, the better the potential to receive a better return through investing.
• Does your mortgage have a prepayment penalty?
• How long do you plan to stay in your home? The main benefit of prepaying your mortgage is the amount of interest that you save.  If you plan to move soon, there is less value in making extra payments.
• Will you have the discipline to invest your extra cash rather than spend it?
• Do you have an emergency fund to cover unexpected expenses? Financial circumstances can change quickly (loss of a job or disability are just two examples) and having funds to cover at least six month’s worth of expenses could save you from borrowing at higher rates to cover day-to-day expenses.
• Do you have significant credit card debt or personal loans? If so, it may be sensible to pay down higher interest rate debt first.
• Are you paying mortgage insurance? If you are, putting extra toward your mortgage balance until you have achieved at least 20% equity in your home may be the better option.
• Are you saving for retirement? If not, consider making the maximum allowable contribution each year to tax-advantaged retirement accounts before prepaying your mortgage.  It is important to consider whether you may be missing out on a generous employer matching contribution in a company-sponsored retirement plan.

There is no one size fits all answer to this question as circumstances vary widely.  It’s important to remember that you can change your current strategy as your goals and circumstances change.

Keep in mind that the rate of return you’ll receive from your investments is directly related to the investments you choose.  All investing involves risk, including the possible loss of principal and there can be no assurance that any investment strategy will be successful.  Investments with the potential for higher returns may expose you to more risk, so consider this carefully when making your decision.

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