By Byron Moore, posted August 7, 2017
Originally published in the News Star and the Shreveport Times on Sunday, August 6, 2017.
Q: Should I be pre-paying my mortgage?
A: Why would you want to do that?
That’s not a definite “no.” But I do not consider “mortgage acceleration” a one size fits all piece of financial advice everyone should follow.
Why do people pre-pay their mortgage? Let’s consider an example.
Joe and Jane Jones are each 35 years old, married and have 2.5 children (they are the average American couple, you see). They have their eyes on a lovely $300,000 house. They can manage a 20% down payment of $60,000 and plan to borrow the balance of $240,000 by taking out a mortgage loan.
The two options they are considering are a 30-year mortgage and a 15-year mortgage. While other options exist, these are by far the most common.
Joe and Jane are offered the 30-year mortgage at a 4% rate. Ignoring escrow payments for insurance and taxes (which would be equal for either option), the mortgage payment for principle and interest would be $1,142 per month.
It is common for 15-year mortgages to be offered at lower interest rates. In our example, Joe and Jane are offered a 15-year mortgage at 3.5%. Even though the rate is lower, higher payments must be made in order to pay off the loan more quickly (in 15 years, rather than 30). In this example, the monthly payments for a 15-year mortgage (principle and interest) would be $1,711.
Many people in this situation take the 30-year loan simply because it is less and the buyer can afford more house.
But as life goes on and incomes increase, Joe and Jane realize some additional cash flow in their budget. Jane attends a class at church that shows her that paying a 30-year mortgage means she will pay much greater interest over the 30 years period than she would pay if she paid enough more each month to pay the loan off in 15 years.
Specifically, paying $1,142 per month for 30 years, they would spend a total of $411,120 for their home. That means you paid $411,120 over 30 years to get $240,000 today. That’s $171,120 in interest.
But if Joe and Jane could somehow scrape together $569 more each month, they would pay the thing off in just 15 years. Paying $1,711 per month for 180 months would total $307,930. Subtracting the $240,000 used to buy the house, that means they paid just $67,980 in interest for the 15-year mortgage.
Wow. $67,980 is a lot less than $171,120. So, obviously, the 15-year mortgage is the better deal, right?
That’s as far as I usually see this kind of illustration taken. But it is woefully incomplete.
All of the above completely ignores the additional money paid each month for the 15-year mortgage. Recall the difference in the two payments is $569. Over the fifteen years that higher payments are made, that is $102,420!
At the 15 year mark, the 30-year mortgage still has about $150,000 left to be paid on it. So if Joe and Jane took the 30-year mortgage and just stuck the $569 difference in a shoe box, they would be about $50,000 shy of being able to pay off the mortgage at that time.
But if they had invested that money, how much do you think they would have to earn in order to have enough to pay off the mortgage? About 5%. Maybe they would do that well over 15 years. May not. Maybe they would have done better. No one knows.
But what if they needed money for some other reason: new car, new braces, lost job, job opportunity, medical emergency, college education, relocation, second home, vacation home, home security system, short-term disability…could be a long list.
My point is that the consideration of a 30-year mortgage and 15-year mortgage is too often reduced to a math problem and not seen in a broader financial light.
My opinion: if you are pre-paying your mortgage before you have adequate protection (insurance) and adequate liquidity for emergencies and opportunities (savings accounts) you are getting things out of order.
Pre-paying your mortgage might be a good move.
But preparing and protecting yourself is definitely the priority.
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