Many of the people I talk with are making extra payments towards their mortgage each month. While this is a widespread and popular idea, I want to discuss some of the reasons it might not be the best option for your situation and offer some potential alternatives to consider.
Before diving in, it’s important to note that sometimes it can make sense to put extra payments towards your debt. For example, any time you carry a credit card balance month-to-month, it can be valuable to throw extra money towards the credit card balance for a couple of reasons.
First, credit card interest rates are high, often ranging from 15 – 20%. Any time you can pay down debt at that high-interest rate, I highly recommend you do so. It’s like earning a 15 – 20% return on your money, as you pay down your credit card debt.
Second, credit card interest is calculated based on the average daily balance. By lowering that balance with extra payments, you can reduce your interest due for that particular month. This is a great way to plug a leak in your financial plan and save money.
Mortgages are very different. These days, mortgage interest rates are much lower than credit cards, with current rates near historic lows. Each additional dollar you put towards your mortgage is getting you less bang for your buck than paying down credit card balances or investing.
Additionally, while paying extra towards your mortgage can save you money in interest by paying off the home sooner, it does nothing to lower your payment until you pay the full amount off and your monthly payment goes away.
Putting extra money towards your mortgage each month is also less attractive when you consider that you cannot get that money back unless you refinance and pull cash out of the home. Your home is not like an ATM – once you get money in, it can be a complicated, expensive, and somewhat painful process to access that money in the future.
This can be especially tough in the event of a job loss or furlough. To get the money out of your home and use it for living expenses, you would need to qualify for a “cash-out” mortgage refinance, which is very difficult or even impossible without a steady income. If you refinance and pull the cash out of your home, there will be the typical transaction costs that come with a refinance, which often range from 3 – 5% of the new mortgage.
Putting extra money towards your monthly mortgage also introduces a hassle-factor. If you’re making additional payments, you want those payments to go towards the loan’s principal rather than interest. However, most mortgage providers require you to specify that, or they may default to applying the extra amount towards interest, which benefits the mortgage provider. This is a small but essential detail that can make that additional payment less appealing.
Last, and probably most important, is all about maximizing the benefit of your hard-earned money. No matter how high your income, we all have a limited amount of dollars. Each decision we make with our money is a trade-off. When it comes to maximizing your money, extra payments towards your mortgage may fall short of the mark for a couple of different reasons.
First, with interest rates being so low and many people recently refinancing their homes, every extra dollar you put towards your mortgage is getting you a “return” equal to your low-interest rate.
If you have an interest rate of 2.6%, then each extra dollar you put towards your mortgage is getting a return of 2.6%. As far as investments go, 2.6% is not a great long-term return (just about equal to the rate of inflation) and is likely not the best use of your additional dollars.
That’s why I recommend setting up a mortgage prepayment fund rather than putting extra money towards your monthly payment. A mortgage prepayment fund is a way to maximize your dollars through investing, while earmarking the fund to pay off your mortgage at a future date.
The concept goes like this: rather than putting extra money towards your mortgage and earning a return equal to your low-interest rate, you take that extra money and invest it into investments with the potential for a higher, long-term return, like stocks and bonds. As the mortgage prepayment fund grows and you continue paying down your mortgage each month, eventually, the amount you have left on your mortgage and the value of your mortgage prepayment fund intersect. That’s when you take the mortgage prepayment fund, pay-off the remainder of your mortgage, and celebrate a big financial win!
A mortgage prepayment fund can be a powerful way to maximize your dollars while still achieving your mortgage-free home goal.
If you’re interested in exploring the possibility of setting up your mortgage prepayment fund, then let’s schedule a time to connect, and I can happily talk you through some of the pros and cons of your unique situation.