Triage Investing Blog reader Trish writes,
“Love the new blog and format! My question is more about personal finance than investing. When do you feel is the best time or strategy for making an extra mortgage payment?”
Thanks for the feedback on the new site Trish.
Previous readers of Triaging My Way To Financial Success will know that I don’t view a residential mortgage as an investment. Instead I like to look at a mortgage as…
• A necessary non-speculative purchase (you have to live somewhere)
• A fixed asset that should appreciate approximately 2%-4% per year
• An asset to be utilized in a Smith Manoeuvre
People need to realize that the behaviour in the real estate market in Canada in the past 10-12 years is not normal, nor sustainable. Housing, historically, has risen fairly close to the increases in real incomes (income adjusted for inflation) during 1950-2000. In the past decade real incomes have moved very little (if at all) while home prices have appreciated to staggering levels increasing the amount of debt individuals and families hold. Housing, just like the stock market, can become speculative very easily because of the emotional aspects of the purchasing process and the vast invested interests of industry to have home prices continually rise. Unsustainable and low interest rates also do not help.
Everyone needs to live somewhere so if a rational person looks to a home as a necessary shelter (with perks) they’re more likely to make a smarter decision, related to their personal finances, than others.
I often tell my friends to think of their home as a “Big Ass Bond”; you should expect the value of that asset to rise approximately 2%-4% per year.
A home can also be an asset used in a very successful investing program known as the Smith Manoeuvre, which I utilize with our mortgage. Basically it is an equity investing program involving tax deduction of mortgage interest and converting your mortgage into a home equity line of credit (HELOC). Million Dollar Journey, a Canadian personal finance blog, does an outstanding job of describing this process and his journey through the program.
To answer Trish directly, I think that paying down your mortgage with extra payments is a smart decision in the long-term, but in the short-term should be examined closely depending on the situation of the individual.
Obviously an individual or couple should pay down higher interest debt first before considering making any additional payments on their mortgage. If you have credit card debt or personal debt in a line of credit (ex: student loan) at a higher interest rate I would advise you to pay that off first before making extra payments on your mortgage. Likewise building savings and investments at the same time as reducing your mortgage is a good idea rather than just doing only one of those things.
I advise friends to plan an extra mortgage payment, if possible, in a few different ways:
When Paid Bi-Weekly Three (3) Times in a Month
If you’re already paid biweekly and make your mortgage payments biweekly this strategy isn’t as beneficial, but for someone who originally set up their mortgage for monthly payments and is now paid biweekly making an additional mortgage payment in months with three pay checks has a similar effect as making biweekly payments. If there is a month in which you receive three pays take your monthly mortgage payment and multiple it by 12 and then divide by 26. This is essentially what you would be paying if you were making biweekly payments. You can make a payment by that amount from your extra pay check to reduce your mortgage.
Example: Monthly Mortgage Payment of $1,000 x 12 = $12,000 divided by 26 = $461.55
This is what I would advise someone to make as a minimum additional payment, if allowed under your mortgage provider, that you can make 2-3 times per year. Most mortgages allow you to pay down 15% of your mortgage each year without penalty and this strategy isn’t a replacement for a biweekly paid mortgage, but does help a little in lessening the interest cost of your mortgage on a yearly basis until you can refinance at the end of your term.
Paid Bonuses or RRSP Refunds
If you receive a year end bonus, gift or a substantial refund from a Registered Retirement Savings Plan (RRSP) making an additional mortgage payment with this money can be an effective method of reducing your mortgage over both the short & long-term. Even $1,000 year paid over the life of a $200,000 mortgage (4.0% paid monthly, 25 year term) helps to reduce the term from 25 years to 23 years. This is likely the most utilized additional payment strategy used.
Save and Set a Date
This seems quite uncomplicated in theory, but anyone who owns a home knows that repairs, life and expenses pop up unexpectedly from time to time to affect your savings. Making extra mortgage payments part of your savings plan is likely the most effective way to reduce your mortgage over the life of its term. What you do is simply allocate a portion of your savings (even $20 week) to making an additional payment on your mortgage once a year to help bring down the interest cost of that mortgage.
Why Make Extra Mortgage Payments?
It simply comes down to interest ($$$)
The most significant long-term cost of a home is not really the principle amount you pay when you purchase the home, but rather the cost of the interest over the lifetime of the mortgage.
If you were to purchase a mortgage for $300,000 at 5.0% for 25 years and made no additional payments the total cost of your mortgage would be $526,131.00. That’s $300,000 in principle and $226,131 in interest!
You would pay 75% of the original value of your mortgage in interest
If you made an extra payment of $200.00 a month ($2,400/year) your total mortgage cost over the same term (25 years) would be reduced to $479,780. A reduction of $46,351 in interest and the mortgage would be paid off in 21 years.
$46,351 in dividend paying stocks yielding 3.5% would be over $1,600 a year in tax efficient income simply by making accelerated payment of your mortgage a priority in your savings plan.
Final Thought
In the end each individual or family will do what is best for them. There may be times when an extra mortgage payment is not a necessity given other circumstances in your life. But reducing the interest cost of your mortgage should be one of the top priorities a home owner has as part of their personal finance strategy.
The question I ask everyone when they ask about their mortgage is, “What could you do with the money you pay to your mortgage every month once your mortgage is gone?”
My answer?
Anything I want!!!
{ 6 comments… read them below or add one }
Hi, good article. You said:
$46,351 in dividend paying stocks yielding 3.5% would be over $1,600 a month in tax efficient income simply by making accelerated payment of your mortgage a priority in your savings plan.
But I think you mean $1,600 a YEAR because I’d like to know which stocks you are buying to yield 42% dividend.
Thanks James for pointing out the typo. I did mean $1600 a year in dividends and I’ve corrected it in the post. 42% dividend would be a unsustainable for sure!
Excellent post. I’ve been putting $1000 a month down on my mortgage while I can because I know it won’t be possible when we have kids. Making the extra payments in the beginning of this new mortgage will totally pay off down the road.
I’m glad your back to frequent posting. Keep up the good work.
Great job Steve. We’re in the same boat too; no kids yet so savings as much as we can before life really starts. Its nice to be back to blogging again. Hopefully readers will contribute enough that I have lots of ideas for content to write about.
I have found that the best time to make extra payment is early in your mortgage. You can practically see the amortization go down as you make new payments or increase your payments. When you have less than 10 years left, the interest savings become less since it’s front loaded
The one concern I have with the Smith Manoeuvre is that it expects you to always retain your loan amount. It basically never goes down in theory. That’s the true Smith Manoeuvre as outlined by Fraser Smith (http://www.smithman.net). Otherwise, you are simply investing from borrowed money from your HELOC. Make sure you follow the rules and buy income generating investments otherwise it’s void.
That’s also a good point I didn’t really touch on in the article PIE. Most people don’t realize that even if you put 20% down your’re paying at least 60% interest & 40% principle each time you make a payment. That obviously changes later on so shifting extra payments to the earlier part of your term helps to reduce the interest cost significantly.
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