Paying extra principal to reduce the amount owed on your mortgage or payoff the debt sooner is never a “bad” thing to do. However, based on your time frame, you may not be accomplishing very much, as this strategy works better for long term savings, not short term like you describe.
I’d 1st recommend that a borrower pay off any other debt such as higher rate ( & non tax deductible) credit cards, student loans, personal loans, car loans, etc. I’d fully take advantage of any 401k opportunities to maximize any matching funds from an employer, make sure you have a proper “cushion” of 4-6 months of living expenses or more, and then, & only then, would I consider paying extra on the mortgage in the manner described.
Once you have paid the extra funds towards the loan, it is hard to “re-access” those funds without a potentially costly refinance. If you have nothing else left to invest in, then paying off your mortgage early is, in my opinion a worthy goal. In the short term, though. I think you’d be better off re-allocating this money towards other expenses.
Paying extra towards principle acts to accelerate the rate of amortization of a mortgage loan. Mortgages are paid back with the lender getting much more interest than principal in the first several years, with the trend slowly changing over time until eventually, more principal than interest is being paid. Paying one extra payment can have the effect of reducing the time needed to repay a typical 30 year loan by 6.5+ years!
Yes, I would say it’s always good to pay down on your loan, unless you are streatching yourself thin to do so. There are two things that happen when you pay extra money down on the principal of your loan.
The 1st is that the balance you owe on your home goes down by exactly the amount you put down. For example, let’s say the balance on your October statement is 200,000 and you are at 6.25% rate on a 30 year note. If you just started this loan your principal and interest payment would be $1231.34 (principal being 189.68 and interest being 1041.66) Lets say you pay that extra $175.00 on top of the 1231.34 payment due. Then your November statement balance would be 200K – 189.68 (Oct. principal pmt) - 175.00 (extra pmt) = 199,635.32.
Now, the 2nd thing that happens is your interest due for November is calculated off the new balance of 199,635.32. Mortgage interest is calculated each month based on the balance you owe, but the payment always stays the same – so you actually pay more towards the principal of your home each month. It’s almost as if you made 2 payments in October – without the extra payment you would still be paying 6.25% interest on the 175.00 plus the 199,635.32 – although the interst on the 175 is just .91 cents - a little less than 1/2 tank of gas nowadays, it does accumulate each month. You no longer are paying interest on that extra money you’ve paid… so you’re saving the $175 each month and you also save the interst on it.
To see this accumulation – let’s say you just made one $175 extra payment and stopped there. As I said before, the interest at 6.25% on the 175 is .91 cents. So, lets multiply that .91 times 36 monthly payments – just that one extra payment just saved you $32.76 over 3 years. Now, that’s not so much money to go crazy over, but if I told you I could give you an 18% increase on your money if you just put it in a CD for 3 years and all you had to invest was 175.00 – you would think differently.
But, if you did the $175 each month – then your savings would accumulate much faster. Your interest savings the 1st year would be $61.18, the 2nd year would be 200.24 and the 3rd year would be 348.18. So basically that 175 each month would save you $609.60 in interest over 3 years and you would have just under $7,000 more equity in your home when you went to sell it, giving you more options when you go to buy your next house. But, if your stretching yourself very thin to do this, you might be better off saving that money in a short term CD and still having use of it, if necessary. You can not access this money you've paid down on your principal of your loan until you sell your house, but you could access most liquid investments. The return on your money woudn’t be as much, but it would still be accessible.
If you are able, paying principal down on your mortgage is almost always a smart thing to do. Here’s why: Assuming you have additional funds to pay down principal, doing so allows you to pay off your loan sooner and over time can save you quite a bit of interest. The easiest example to consider is that of a snowball rolling downhill.
Interest accrues daily on a mortgage loan based on the current principal balance. Let’s say for example that you have a $200,000 mortgage at 6.0%. This means that you would have approximately $1000 worth of interest accruing per month in the beginning of the loan. On a 30 year loan, your total principal and interest payment would be approximately $1200. This means that $200 of the payment is going towards principal if you pay the regular amount due. Let’s assume however that you will pay an additional $1000 towards principal. You now have a principal balance in month 2 of $198,800 (the $200 that would regularly apply to principal plus the $1000 extra). This would mean that interest is accruing on less money than the $199,800 that would be your normal principal balance in month 2. From month 2, on to the remaining 358 payments of the loan, you will never pay interest on that additional $1000 again. If you repeat this process monthly (even if it’s only an additional $100 per month), it will act like a snowball rolling downhill and save you substantial interest over the life of the loan.
Even if you are planning on leaving your home in a few years, at the time you sell, you will owe less than if you didn’t pay the additional principal, and you would have saved interest over those 2 to 3 years.
Great question and due to today’s economy has a very simple answer. No! A thousand times NO.
When considering today’s real estate market paying down your mortgage only means you are running a race you will never win. Consider this…across the USA today homes are rapidly declining in value and have been for over two years now. By paying down your mortgage with an extra principle payment each month you are throwing money away.
Let’s say you purchased your home for 200,000 with a mortgage of 160,000 two years ago. Let’s be real conservative and say your home lost 5% in value each year. 2007 Value = $190.000 & 2008 Value = $180,500. Now let’s say you added $175 to your principle payment each month for the last two years ($4,200). So if you reduced your mortgage amount by an extra $4,200, but lost $19,500 in equity, what is your net result? Your $4,200 has been consumed by the equity loss in home depreciation.
Remember, cash is always KING. This is especially true in a down economy. You never want to be caught with limited cash. While home values continue to fall, it is best you keep your extra cash separate from your home equity. Ask yourself, would you purchase a company or a stock that you knew was losing money or value year-over-year? Same concept applies here.
Continue making your full payments on-time every month and when you are ready to sell your home in 2 to 3 years you will have your equity to realize after the sell, but more importantly, you will have the cash you have saved sitting in secure money market account and/or secure bond that has safely increased in value.
There are additional scenarios to go over, however, I will leave that for another time.
Thank you again for your question today.