Money-Saving Mortgage Advice
There's nothing like owning your own home free and clear. That's a goal near to the heart of almost everyone who has ever held a mortgage. Oh, the things you could do without a mortgage payment!
Paying off a mortgage is a noble goal, and one that can serve you well in retirement. But hang on, there's no rush. Despite the claims that you can save a fortune in interest by paying off a mortgage early, spreading the payments out over 30 years can be much smarter than putting your extra dollars into additional mortgage payments.
The interest paradox
While it is very true that a shorter mortgage incurs far less interest than a longer one, simply paying off your existing mortgage faster might not save you as much as you think. The key factor is that you pay most of the interest in the early years. It takes eight years to pay down the first 10% of the principal when you amortize a loan over 30 years. The rest of what you've shelled out is interest. By the time you are halfway through a 30-year mortgage, you've paid 67% of the interest. By year 20, two-thirds of the way through the mortgage, you've paid 84% of the interest.
Starting to make accelerated payments halfway through a 30-year mortgage will save you very little in interest. It would be better to put those extra payments into a money market account until they are actually due. Let the bank pay you interest instead.
Another problem is the way some lenders handle additional payments. Not all lenders automatically recompute the interest you owe if you reduce your principal faster than they expect. Instead, they follow their amortization table, which divides each payment into a set amount of interest and principal. So even though your balance is lower, the interest you are paying doesn't change. With this type of mortgage, an early payoff amounts to a long-term, interest-free loan to your mortgage company. Yikes!
The paradox is that even if you work it right and do save tens of thousands of dollars in interest, that decision could cost you far more in terms of lost opportunity. The real question is: What is the best use of your money?
Imagine if you will, an anti-mortgage account. Instead of sending a bunch of extra bucks to your mortgage lender every month, you send them to a broad-market index fund.
Let's look at what might happen with a $100,000 mortgage at 7%. You could pay it off in 30 years at $665 a month, or in 15 years at $899 per month -- and you'd save about $78,000 in interest with the 15-year option. But suppose you went for the 30-year option, sending $665 to the mortgage company and sending $234 to an index fund -- your anti-mortgage account. That's the same amount out-of-pocket every month, right?
Fast forward 15 years. Your mortgage has been paid down to $74,018 and you have $106,397 in your anti-mortgage account (assuming an average annual return of 11%). At that point, you could, if you chose, convert your anti-mortgage account to cash, pay the capital gains taxes due, and use what's left to pay off your mortgage. Assuming a federal capital gains tax of 20% and a state capital gains rate of 5%, you'd even have about $5,000 left over -- but don't spend it, you'll be needing new carpet soon.
The anti-mortgage account gives you options. You could cash it in and pay off your mortgage early if you prefer, or you could keep saving and building up your net worth as you pay down your mortgage. Or you could do any of the myriad other things that cash money is good for.
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