Paying down your home mortgage balance faster than the loan contract requires can be a more powerful concept than you might think. Not only can it provide peace of mind, it can help you build a significant retirement nest egg so you can enjoy your golden years — and live in a debt-free home.
Here’s what you need to know about the strategy and how to proceed.
Basics of Paying Off a Mortgage Early
The accelerated mortgage pay-down idea only works for individuals who have positive cash flow and/or available cash. It’s not an option for those who are already struggling to pay their monthly bills.
The accelerated mortgage pay-down idea is only appropriate if you’re looking for a very conservative, risk-free way to invest some surplus funds. Basically, following this strategy results in earning a rate of return equal to your mortgage interest rate on the funds used to pay down the mortgage sooner than required. So if you believe you can earn a high rate of return with other investment opportunities, you’re unlikely to be excited about earning 5.5% (or whatever your mortgage interest rate happens to be) by paying off your loan early.
Finally, the accelerated mortgage pay-down idea is far more powerful if you continue pumping the monthly accelerated mortgage pay-down amount into a retirement savings account after your mortgage has been paid off.
With the preceding thoughts in mind, here are some illustrations to show how the accelerated mortgage pay-down strategy might work.
Illustrative Results for a 45-Year-Old Individual
Let’s say you’re 45 and in good financial shape. You have cash on hand and positive monthly cash flow after paying bills. Even better, you expect to be in the same comfortable position for the foreseeable future.
Assume you have a $400,000 remaining balance on a 30-year first mortgage that you refinanced two years ago at a fixed rate of 6%. Your monthly payment for principal and interest is $2,460.
Here’s the catch: You have a whopping 28 years to go before the mortgage will be paid off if you stick to the prescribed monthly payment schedule. You will be 73 years old when the mortgage is paid off. This is not a great situation. Until recently, the “conventional wisdom” was to not worry about how old you might be by the time your mortgage was finally paid off. That was because many people thought home prices were “certain” to go up 8 or 10% a year. We know better now.
Strategy No. 1 (Aggressive Pay-Down): Say you decide to start paying $4,000 per month instead of making the scheduled monthly payments of $2,460. You will pay off your $400,000 mortgage balance in about 11 years and 7 months, at about age 56 1/2, instead of paying it off in 28 years, at age 73. You will earn a guaranteed 6% rate of return because that is the rate of interest you avoid on the accelerated principal payments. If after the mortgage is paid off, you continue the program for another 8 1/2 years by putting $4,000 a month into a retirement savings account that earns 6% annually after taxes, you will accumulate about $530,000 in the account by age 65. This seems like a more reasonable plan than sticking with the status quo and making mortgage payments until age 73.
Strategy No. 2 (Really Aggressive Pay-Down): With this strategy, let’s say you decide to get super-aggressive with the accelerated mortgage pay-down idea. You start paying $5,000 per month instead of making the scheduled monthly payments of $2,460. You will pay off this $400,000 mortgage balance in about 8 1/2 years, at about age 53 1/2, instead of paying it off in 28 years, at age 73. You will earn a guaranteed 6% rate of return because that is the rate of interest you avoid on the accelerated principal payments. Then, for another 11 1/2 years, you put $5,000 a month into a retirement savings account that earns 6% after taxes. You will accumulate about $990,000 by age 65.
Strategy No. 3 (Less-Aggressive Pay-Down): In this scenario, you can be less aggressive. You start paying $3,500 per month instead of making the scheduled monthly payments of $2,460. This only requires an extra payment of $1,040 per month. Paying $3,500 per month allows you to pay off your $400,000 mortgage balance in about 14 years and 2 months, at about age 59, instead of paying it off in 28 years, at age 73. If after the mortgage is paid off, you sock away $3,500 a month into a retirement savings account that earns 6% after taxes, you will accumulate about $300,000 by age 65.
Illustrative Results for a 55-Year-Old Individual
Let’s now assume you are 55 instead of 45. Everything else is the same. If you start paying $4,000 per month instead of the scheduled payments of $2,460, you will pay off the $400,000 mortgage balance in about 11 years and 7 months, at about age 66 1/2, instead of paying it off in 28 years, at age 83.
It’s Advantageous to Continue the Program After Pay Off
The accelerated mortgage pay-down strategy can clearly be beneficial in and of itself — because interest charges are avoided and debt is eliminated from your personal balance sheet. Another advantage is that you can stop and restart the program anytime.
However, the biggest payoff is reaped by those who have the cash flow and discipline to continue even after the mortgage is gone. By “continue the program” we mean taking the monthly amount that was previously dedicated to the accelerated mortgage pay-down strategy and putting it into a retirement savings account. As the illustrations show, impressive amounts of retirement savings can be accumulated in this fashion.
Three Considerations That Can Affect Your Decision
1. The Impact of Refinancing at a Lower Interest Rate. Instead of paying off your mortgage faster, you might be able to refinance your 6% mortgage at a significantly lower rate. That would be great! The accelerated mortgage pay-down strategy is still attractive as long as you are satisfied with earning a guaranteed, risk-free rate of return equal to the interest rate on the refinanced mortgage.
For instance, if you are able to refinance at 4 percent, you can earn a guaranteed, risk-free return of 4 percent on the accelerated mortgage payments. In today’s world, that’s not all that bad.
2. The Impact of Mortgage Interest Deductibility. What about the argument that you’ll lose tax deductions because your interest charges will go down more rapidly than if you stick with your scheduled monthly payments? In the first place, keep in mind that there are several tax-law limitations on your ability to deduct home mortgage interest. These limitations may reduce your mortgage interest write-offs.
Even if you assume all interest charges will always be fully deductible in future years, following the accelerated pay-down strategy equates to earning a guaranteed, risk-free taxable rate of return equal to your mortgage interest rate. Where else can you earn a taxable guaranteed, risk-free rate of return of 5 or 6%, or whatever your mortgage rate happens to be?
3. The Impact of Future Inflation or Deflation. While the faster mortgage pay-down strategy yields guaranteed, risk-free results, it is still not foolproof. If we enter a period of significant inflation, paying down your mortgage sooner than required may no longer make sense.
In this situation, it may be better to stop the accelerated pay-down program, allow the mortgage term to stretch out, and pay the remaining balance back with cheaper inflated dollars. On the other hand, the accelerated pay-down strategy will work well during a period of deflation, because the mortgage is being paid down sooner when dollars are cheaper rather than later when dollars are more expensive.
© Copyright 2017. All rights reserved.
Brought to you by: Peterson Whitaker & Bjork, LLC