Most people would agree that living without a mortgage payment would be a nice thing . . . but is it worth pre-paying your mortgage to try and get the balance paid off?
The answer: Yes . . . but probably, No.
A lot of people are overly consumed with the idea of paying off their mortgage. Many sending in an extra few dollars each month, rounding up their total payment to the nearest hundredth or even adding $100 or $200 to their payment, hoping to make a dent in what is most probably their largest debt. Investors, keying in on the consumer’s drive to do this, have come up with ways to “help” (and I use that term very loosely) by offering bi-weekly payments — sometimes called “Equity Power Program” or something of the like — selling the payment plan as a smart-fix to paying off your mortgage early.
Essentially, making payments every 2 weeks is the equivalent to making 26 half-payments per year, which is the same as make 13 payments per year. So, if you want to avoid the “administrative fee” of signing up for the “Equity Power Program” (usually $50 to $295 — ouch!) and if you want to avoid the transaction fee usually associated with this type of plan and charged at each half-payment (usually $1 or $5 per period), you can accomplish the EXACT same thing by sending in one extra payment per year or by sending in an additional 1/12th principal-and-interest-payment each month. But . . . you probably shouldn’t even do that.
So . . . back to the question at hand. Should you pre-pay your mortgage? The answer depends on a few things.
# 1. Do you have any other debt (credit cards, student loans, car loans, a home equity line of credit)? If you do, you should pay those off completely before adding $$ to your mortgage payment.
# 2. Do you have cash in the bank? Most financial experts would advise you to have four to six months worth of living expenses saved in some type of liquid asset account (checking, savings, money market, etc). If you do not have this type of reserve account, you should save for this first.
# 3. Are your 401K contributions at work maxed-out? If you have numbers 1 and 2 under control, money growing in your 401K should pay a better return than the tax-deductible cost of your mortgage.
# 4. Are your other retirement and college saving plans being utilized fully? If not, put more money here to make sure you are on track to meeting your goals, more so than paying down your mortgage.
# 5. Assuming that 1 through 4 are in order (and even if you don’t have them in order, but you are just dying to pre-pay your mortgage), then the final question is possibly the most important. Do you have a fixed rate mortgage or an adjustable rate mortgage (ARM)? And if you have an adjustable rate mortgage, does it have an automatic recast option (most interest-only ARMs do have this options; most others do not).
Here is why this is important:
On a fixed rate mortgage, pre-paying the mortgage does not change next month’s payment — it does not “save” you interest in the same sense as it would if you prepaid a credit card or car loan (most credit cards and car loans have interest calculated daily based on the outstanding balance). On a fixed rate mortgage, the amortization schedule is set the day that you close on your loan, so additional payments that you make towards the principal save you interest simply because you are saving yourself having to make the 360th or 359th payments (for example).
On an interest-only adjustable rate mortgage (for most investors) the amount of monthly interest charged recalculates based on the outstanding balance. This feature is called re-casting, or automatic re-casting — so, as you pay down the principal balance of the mortgage, the interest charged is reduced. So, prepaying the mortgage really DOES “save” you interest.
Here is an example. You and I both buy houses and mortgage $200,000. You get a 30 year fixed at 6.5% and I get a 10/1 interest-only ARM at 6.375%. Because of the lower interest rate and the interest-only payment, my payment is $202 less than yours (yours, though, includes a principle and interest payment). If I take the additional $202 per month and pay down the mortgage (assuming that it is automatically recasting each month) who will pay more interest over 5 years? 10 years?
Hmmm . . . I’m working on a spreadsheet to calculate the savings. Check back soon to find out the answer.