Paying off a mortgage is one of the most basic milestones of financial freedom. Life without a mortgage payment-does it get any better than that?
But a mortgage is a huge debt, so most financial advisors recommend paying it off gradually with additional monthly principal payments. That can chop years off the length of a mortgage loan term and save thousands in interest as it does.
Good deal? Not necessarily. Yes, it’s a good way to retire your mortgage early, but it’s not without consequencesâ”three of them that I can come up with. If you are retiring in Australia and want some info on mortgages, check out the one of many mortgage brokers sydney.
Loss of liquidity
When you make extra principal payments, you effectively tie money up in your home. Once money is paid into a mortgage, the only way to get it outâ”should the need ariseâ”is either by selling the home, or by taking a new loan on it. You probably don’t want to sell your house, and taking a new loan defeats the purpose, if paying it off is what you were trying to accomplish.
Houses aren’t particularly liquid, especially these days. Not only is it hard to sell a house, but there’s virtually no way that you can cut off a piece of it and sell it to raise cash the way you could with a mutual fund. Simply put, a house isn’t a liquid asset, and any money you pay into it will be effectively lost until the day the house is sold or a new mortgage is taken out.
Additional principal payments will actually reduce your liquidity, should you need money for emergencies, for investment, or for payoff of non-housing debt.
You won’t lower your monthly payment
If your mortgage is fixed rate, your payment will also remain fixed until the loan is paid in full. There will be no benefit in the form of a lower house payment as a result of additional principal payments. If you’re payment is $1,000 a month with a $100,000 mortgage balance, it will still be $1,000 when you pay the loan down to $20,000.
Additional principal payments will do nothing to lower your monthly expenses, and will even reduce your cash flow by the amount of the additional principal contribution. By making additional principal payments, you may reduce your loan term from 30 years to, say, 15 years, but you will still have the same monthly mortgage payment (plus extra principal) for each and every one of those 15 years.
The mortgage tax deduction benefit will go away quicker
This is a factor seldom included in the additional principal discussion: as you pay down your mortgage balance, the amount of interest you pay on the loan will decline faster and, as a result, you’ll have less mortgage interest to deduct on your income taxes.
For a lot of homeowners, the tax deductibility of mortgage interest is a major reason why they can afford their payment, and why owning a home is more affordable than renting, which has no income tax benefits. The $1,500 a month payment that was reduced to $1,000 by the mortgage interest deduction, will move closer to the actual $1,500 as each year passes. The bigger your house payment is, the more painful this will be.
Instead of making additional mortgage payments, try thisâ¦
There’s a way to payoff your mortgage early without having issues with liquidity, monthly house payment or loss of tax deductions. Instead of making additional monthly principal payments on your mortgage, put the extra payments into a mortgage sinking fund.
Before you get to thinking that a sinking fund is something exotic, understand that it’s just an accounting term that describes an account that’s set up to retire a debt. The idea is that you make periodic payments into the sinking fund that will enable the eventual payoff of the debt, without making payments to the debt itself. The sinking fund itself can be a bank account, money market fund or certificates of deposit that hold the money in a safe place until it’s sufficient to payoff the debt.
There are several advantages to using the sinking fund method to payoff your mortgage rather than the additional principal method:
- Since the money is in an account under your control, you keep liquidity until the loan is paid in fullâ”you’ll have money for emergencies and investing opportunities in the meantime
- You can earn interest on money you’re salting away to payoff your mortgage
- The sinking fund enables you to payoff the mortgage and eliminate the payment on the same day
- Your mortgage income tax benefit will remain fully intact until the time of payoff
- Should you decide that you don’t want to payoff the mortgage, you still have the money that would have paid it offâ”no need to sell the house or take a new loan
- You’ll be in a forced savings routine, and once the mortgage is paid off, you can continue saving, but with the mortgage payment gone, you’ll have even more to save
There are so many reasons to payoff your mortgage using a sinking fund that it’s surprising it doesn’t get more attention. Maybe it’s because the idea of saving up a six figure savings balance is beyond comprehension to many people. But think of it this way: if you can payoff a six figure mortgage, you can just as easily build up a six figure sinking fund to make it happen.
Do you think you can do it?
Just wanted to drop a quick note to say I really appreciate this article. As a new homeowner I have always been told to make an extra payment a year and it will knock 6-7 years off your mortgage. But even with what looks to be a rebounding market building equity isn’t what it used to be. I appreciate the alternative view on this.
Can I ask a follow up question? We put down 10% on our mortgage so pay PMI until something like December 2017. Would you recommend paying down to get to the 20% before setting up this sinking fund or would you start now?
Hi Paul-The “book” answer on paying down your mortgage would be YES, but real life isn’t a book. How comfortable are you financially? Do you have enough savings and enough room in your budget to accomodate the exta payments? If yes, go for it. If not, make sure your near term financial situation is under control first. Giving up too much liquidity is a major reason for mortgage delinquencies and foreclosures. Translation: don’t do anything that makes you financially uncomfortable. This is especially true if you have or plan to have children. Kids are a contingency unto themselves so you need to be prepared.
In your case, since you’re a new homeowner, the sinking fund is probably a better idea. You’ll have the cash if you need it, but once you reach a point where you can pay the loan down to 80% (actually I think it’s 78%) of the property value, you can pay the loan down in one shot. Think long and hard because refinances and 2nd mortgages are much harder to get now, so any money paid into the mortgage will be close to impossible to get back should you need it for something else.
You’ll probably get a different answer from someone else, but without knowing your specific circumstances, that’s my two cents.
There is one more thing to keep in mind: that stuff that happens. For instance, getting laid off in a recession. One thing I did a few years ago, was to make house payments in advance. They here is to pay the EXACT amount of the monthly payment each time. Most banks recognize that as paying a future month’s payment. Others take it as a simple equity pay-down and still require you to make the next monthly payment. Our bank took these as future payments, and the end result was we eventually had like six or seven months’ payments already made. I did lose my job, as it turned out, but we didn’t need to make house payments for several months.
Just one additional thought…
Good point. I’ve never actually thought of that, that’s pretty useful in such a fragile economy as ours right now. I’m glad to hear you were able to meet that job loss head on.
Hi William-That worked because you were paid in advance, but it does’t apply with extra principal payments. The bank is more concerned with collecting monthly interest and additional principal payments don’t cover that.
Even with the advance payments it’s best to check with the lender to see how they handle that. As you said, some will consider it to be additional principal or equity payments. You probably needed to make separate payments because if you lumped them it’s anyone’s guess how the bank would have processed it.
Excellent tactic if the lender will accept it!
Hello, Great article. I’m from Canada, and I just wanted to share with you a new mortgage product that has been introduced up here, that may find its way down to you all. Its called the You’re the Boss mgt @ Coast Capital Savings Credit Union. Up to 30% of original amount borrowed can be put toward the principle annually (whenever you want)plus up to 30% on each mgt payment. Now heres the amazing part…. I can take out any or all of my extra payments anytime I want with no penalty, interest, or fees!!! I’ve been putting extra $$$ in whenever I can, (gifts, emergency$$ , etc) and have paid off $30000. in the last year alone, with no stress re loss of liquidity!
Thanks for this article, Kevin. You make great points, and people should definitely consider their options and their situation before settling on any financial action.
Question about the mortgage interest tax deduction - while I understand it’s a tax benefit, in the long term, wouldn’t you save more money if your interest declines faster by making extra payments? I know this wasn’t your sole reason for not making extra payments, but paying, say, $500 in interest to save $100 in taxes still means you’re losing lots more money to interest. Or am I looking at it incorrectly?
Hi Eric-That’s a good point, and it largely depends on your income tax bracket. If you’re at the 10% marginal rate, what you’re saying is true. But if you’re at 35%, plus state income taxes, that annual tax benefit won’t be so easy to give up, even in the name of paying off the loan quicker.
Here’s the thing-let’s say your monthly payment is $1500-part of how you’re able to handle the cash flow is because of the tax break. If you prepay your mortgage gradually and the tax break diminishes, you’ll still have your $1500 payment, but with less of a break. If you wait and pay the loan off in a lump sum, you’ll keep the tax break, and it’s attendant cash flow advantage, up until the day the loan is gone.
Does that make sense?