Does it always make sense to make extra payments on mortgage?
Ilyce Glink & Samuel Tamkin
Real Estate Matters, Tribune Media Services
February 18, 2012
Q: I hear and see so many financial advisors and experts recommending that people pay off their mortgages by making an extra mortgage payment each year. The reality is that it would be easier for the average person to include an extra $83.34 on a $1,000 mortgage payment than to come up with an extra $1,000 at the end of the year. What the heck, round it up to an extra $85!
While it makes sense to make extra payments now to reduce the principal on a high interest loan, it is very likely future inflation will make the prospect of paying extra dollars now (which are dear) to save cheap dollars later a bad business proposition.
A. You've made two very good points. First, you say that people are better off rounding up their payments to pay down their home mortgages because they will probably not have the money at year's end to make that extra monthly payment. We agree. If you don't have the financial discipline to save money in a separate during the year to pay down your mortgage balance, you are better off rounding up your payments on a monthly basis.
Not only are you better off because you don't have to worry about it at the end of the year (at the holidays, when cash is extremely tight for most families), but you'll get an increased benefit by paying down your mortgage throughout the year. Any payment that reduces principal faster means you're paying less interest on that borrowed sum the following month. So even more of your monthly payment goes toward repaying your principal.
The bottom line is that any increased payment toward your mortgage will save you interest expense in the long term -- at least when it comes to fixed-rate mortgages.
Now, if you are not able to save much money during the year, it's unlikely that you have the discipline to invest your money and more likely that you are spending all that you have. For this type of person, saving on his mortgage payments is probably better in the long term, even given your excellent second point about the corroding power of inflation.
You are correct that with historically low interest rates available, now is a good time to borrow money. In fact, as we were writing this, Freddie Mac's weekly mortgage survey found that 30-year fixed rate mortgages were available for under 3.85 percent.
Financially savvy homeowners borrow when interest rates are low and use that cash for other investments. If you borrow money at around 3 percent (e.g., if you opt for a 15-year mortgage), you can be certain that rates will increase down the road -- and you may even find that your interest rate is lower than the inflation rate. At that future date, you will be ahead of the time when you borrowed the money.
If you borrow $100,000 today at 4 percent and put money into a savings account, you might be lucky to get up to 1 percent per year on that money. So you'd be losing about 3 percent on that money per year. But if five or 10 years down the line, interest rates go up to 8 percent and savings accounts pay 5 percent, you'd be making one percent on the money you borrowed without doing much of anything and taking virtually no risk.
Of course, the right course of action depends on person's ability to invest and their ability to save. Many people are unable to save for a rainy day, much less for retirement. For these people, making extra payments on the mortgage can be a safe way to put money into their home, reduce their debt, and get to the day when they own their largest asset free and clear. This is how most Americans have traditionally built wealth.
On the other hand, if you are underwater on your mortgage, paying down the debt may not be the best solution, particularly if you are planning to sell in the near future or are heading into foreclosure. The dynamics of paying down your mortgage may work better if you have equity in your home.
Copyright © 2012, Tribune Media Services