- Making extra mortgage payments can cut your interest expense dramatically.
- Look at your entire financial picture before contributing more to your mortgage.
Should I make extra mortgage payments to slash my mortgage interest expense?
Can I pay extra money for the principal plus the monthly payment for the mortgage loan? I heard this way I lower my principal and is a fast way to pay off my house.
The short answer is yes, every mortgage I have seen allows the borrower to make extra payments or add to their monthly payments. But is it smart to do so? This is a more complicated question than it appears, and not because of the math. Before we get into the tough questions, let us look at the mortgage in isolation. For the sake of argument, let us assume you have a $200,000 mortgage balance, a 5% fixed interest rate, and a 30-year (360-month) loan.
The amortization table with no extra payments looks as follows:
| Payment Number | Monthly Payment | Principal | Interest | Total Interest | Remaining Balance |
|---|---|---|---|---|---|
| 1 | $1,073.64 | $240.31 | $833.33 | $833.33 | $199,759.69 |
| 180 | $1,073.64 | $507.94 | $565.70 | $129,589.30 | $135,259.87 |
| 360 | $1,073.64 | $1,069.19 | $4.45 | $186,511.57 | $0 |
The table above shows us that the homeowner pays the lender $186,511 in interest if the homeowner makes only the monthly payments and nothing more.
Now let us look at the amortization table if the homeowner adds $75 per month to the monthly payment:
| Payment Number | Monthly Payment | Principal | Interest | Total Interest | Remaining Balance |
|---|---|---|---|---|---|
| 1 | $1,148.64 | $315.31 | $833.33 | $833.33 | $199,684.69 |
| 180 | $1,148.64 | $666.47 | $482.17 | $122,959.10 | $115,054.67 |
| 310 | $1,148.64 | $1,044.91 | $4.35 | $157,128.67 | $0 |
Adding $75 a month cuts the total interest expense by almost $30,000, and reduces the time to pay off the loan by almost 4 years.
Adding an extra $1,073.64 payment each year, a 13th payment, has almost the same effect as adding $75 per month to each payment. Does this mean that adding $75 per month or a 13th payment per year is always a good idea? After all, it saves nearly $30,000 in interest expense. The answer is no, not always.
Retirement Accounts
If you have not yet reached the limit on your 401(k) or IRA accounts, the extra money you would use to pay the mortgage is better off contributed to these accounts. In a 401(k) plan, you can typically contribute up to $12,000 annually. In an IRA (individual retirement account) you can usually save up to $4,000 annually (although this limitation may vary). Keep in mind that the contributions to these accounts are not taxed. Remember also that your income tax deductions on your mortgage expense decreases later in the life of the loan. In our examples above, we can see the interest portion of the loan in the last year is essentially pocket change.
In other words, it may not be wise to sacrifice your retirement investing at the expense of cutting your mortgage interest expense.
Investing
You could also use the $75 per month or $1,073 annually to invest in other short-term high-yield products such as mutual funds, but it entirely depends on the amount of risk you are willing to take. To justify the risk the after-tax returns need to exceed the interest cost on your mortgage.
Conclusion
If your retirement investing is at the maximum amount allowable, and you have an investment plan in place, then by all means use any surplus cash on your mortgage to shorten its life. However, if you are not contributing to your employer's 401(k), or have not contributed to an IRA, then putting money into your retirement fund would be a smarter use of your surplus.
I hope this information helps you Find. Learn & Save.
Best,
Bill