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If you follow such personal finance gurus as Suze Orman, Dave Ramsey, and many others, you’ve heard them tell you repeatedly to pay down your home mortgage as quickly as possible. Whether by making an extra payment each year, or by adding extra money to each payment, they want you out of that debt as quickly as possible.
Becoming debt-free as soon as possible is certainly a laudable goal, but with very limited exceptions following this advice regarding your mortgage actually puts you at higher risk of losing your home! Let’s see why…
What Happens when You Pay more than Your Monthly Mortgage Payment
Say your home mortgage is the most common type — a 30-year fixed-rate loan. Each monthly payment first covers all the interest since your last payment, with the remainder reducing your principal just enough so that 30 years after you took out the loan, it’s paid off in full.
When you pay more than required, you reduce the principal faster than the original duration, and the loan is paid off faster. That certainly seems like a good thing, right?
So why is it such a terrible idea?
To answer that, you have to understand that when you pay your principal down faster, you’re not paying the next payment (or a portion of it) earlier. What you’re doing is reducing the balance on which the interest is calculated. This means that the interest portion of all your following payments is slightly reduced, which slightly accelerates the rate at which the principal goes down. In effect, you’re paying off your last few payments early.
The Good Part of Prepaying Your Mortgage
The reason why personal finance gurus want you to pay off your mortgage as soon as possible is twofold. First, and less important, is that it reduces your total interest cost over the life of the loan.
Second, once your mortgage is paid off, there’s no risk of losing your home if you can’t make mortgage payments on time, e.g. if you lose your job or have a major medical expense.
Why Prepaying Your Mortgage Doesn’t Save You all that Much (and may Actually Cost You Money)
While paying interest in general is not a particularly good thing, in the case of a mortgage, it’s not that bad, for three reasons. First, because the loan is secured by your home, the interest rate is lower than most other loans.
Second, Uncle Sam picks up part of the interest tab through the mortgage interest deduction (assuming you itemize). If your marginal income tax rate (federal, state, and local) adds up to say 30%, and say your annual percentage rate (APR) is 4%, the deduction reduces your taxes by about 1.2% of your interest payment (30% of 4%), leaving you to cover the remaining 2.8%.
Third, mortgages in the US aren’t pegged to the consumer price index (CPI), so inflation eats away at the value of the dollars you pay, and more importantly, the dollars you still owe. Say inflation is 2% per year, that means that the value of your loan principal drops by about 2% per year, which reduces your effective interest cost by that 2%.
If you combine the tax benefit with the impact of inflation, your real interest cost in our example is only about 0.8% (2.8%-2%, though more accurately it’s 1.028/1.02 – 1 = 0.78%).
What’s more, if inflation runs high, your real net interest cost might become negative, which means you’d actually be making a net profit on your mortgage! That’s even without assuming any appreciation in the value of your house.
The Really Really Bad Part of Prepaying Your Home Mortgage
How about doing away with the risk of losing your home?
That too is not exactly as advertised.
Say you took out your mortgage five years ago, and have been making an extra monthly payment each year, your payoff date has probably been accelerated by several years — let’s say it’s now only 17 years away instead of 25 years, assuming you continue making those extra payments.
Since we’re talking about the risk of losing your home, let’s say you suddenly can’t make your mortgage payments. Can’t you just call your friendly lender and ask her to recharacterize your early principal payments as if they were your regular payments that you simply can’t make at the moment, at least for the next five months? That would push your payoff date back to the original date 25 years from now, but at least the bank won’t foreclose for several months, by which time you may again be able to make payments. That would be great, right?
Unfortunately, if you try that, your lender will laugh in your face! Well, not really, since she’s probably a good person; she’ll just explain why things don’t work like that. You’re still required to make your payment each month, or the bank will foreclose on your home.
What You Should Do with the Extra Money Instead of Prepaying Your Mortgage
Let’s say that instead of making extra payments against your mortgage principal you invested that money conservatively. After making an extra month’s payment each year for five years, you probably have at least six or seven months’ worth of payments in your investment account.
Now, if you were to lose your job, you could use that extra money to make payments for six or seven months, giving you the extra time you need to get back on your financial feet.
The best part is that if you never lose your job and continue investing that extra cash each year, you can still pay off your loan in full years early. Of course, that doesn’t mean you should, because as mentioned above you might actually be making money off the darn thing!
About the author:
My career has had many unpredictable twists and turns. A MSc in theoretical physics, PhD in experimental high-energy physics, postdoc in particle detector R&D, research position in experimental cosmic-ray physics (including a couple of visits to Antarctica), a brief stint at a small engineering services company supporting NASA, followed by starting my own small consulting practice supporting NASA projects and programs. Along the way, I started other micro businesses and helped my wife start and grow her own Marriage and Family Therapy practice. Now, I use all these experiences to also offer financial strategy services to help independent professionals achieve their personal and business finance goals.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.