A hodge podge of mail lands in your mailbox. If you’re a shopaholic, you’ll collect the flyers from the department stores and discard the rest. You’ll look eagerly for that bottle of perfume to see if it’s on sale yet, or else if the throw pillows are now selling at a reduced price. But, if you’re the type who wouldn’t mind a financial education every now and then, you’d keep the bank flyers and bulletins and discard the rest.
Banks are usually good at sending bulletins out. They insert a pamphlet or two in your financial statements or credit card bill. One major bank we do business with will occasionally talk about economic trends or what mutual funds have yielded impressive returns in the last quarter. Or they’ll publish questions from the public and provide answers. Like these:
- Should I borrow from my retirement funds as a first time home buyer to buy a new home?
- Should I put more money into my retirement funds or pay down debt and postpone the purchase of a new home?
- How much do I need to continue the same lifestyle I have at present?
- Is it worth making that extra mortgage payment or should I put it into a guaranteed investment certificate instead?
Once a week, the newspaper will have an entire page in the Business Section that assesses an individual’s personal financial situation (fictitious names are used, of course) and then invites three to four experts to comment on the individual’s situation. The evaluations are interesting because each expert presents a unique solution worth mulling over.
By regularly reading these sections and browsing over those flyers in the mail, you get a clearer idea of the more common recommendations on how to improve your financial situation, one of which is to water down that mortgage by making extra payments.
Reasons for Making Extra Payments on a Mortgage
We all know that during the first five to seven years of the mortgage (much will depend on the amount of the mortgage), the payments we make go towards paying the interest and not the principal. This is why when we look at the outstanding balance, it does not seem to change. The little change we notice is perhaps the balance going down by a mere $50.00-$60.00. That’s because when we make a weekly payment of say $200.00, approximately 75% of that $200.00 goes to paying the interest and only 25% goes to paying the balance.
No wonder many people hesitate to change their status from being renters to homeowners. A mortgage is a huge debt on our backs lasting oodles of lifetimes.
The trend is that couples who start a mortgage in their late 20s will finally pay off their mortgage at about the same time they retire, unless they’ve been making those extra payments religiously. Some exceptional individuals can pay off a mortgage in say 15 years (instead of the usual 25) only because they were determined to make extra payments monthly, and have saved up sufficient funds to make a lump sum anniversary payment annually. We’ve even heard of cases of individuals who paid off their mortgages in 10 years, thanks to those extra payments they made.
So unless you’re a wealthy Chinese from Hong Kong, a Warren Buffet or the Prince of Brunei who are perfectly capable of paying for a house in cold cash, you’ve gotten yourself into a mortgage which you need to pay off slowly during your most productive years.
Judging from our research and multiple conversations with financial planners, there are good reasons for making extra payments on a mortgage:
You build equity faster – the magic word here is equity. If you’re a renter, your equity is limited to your material possessions and savings – maybe some stocks and bonds – but if you’re a homeowner, your equity is your house. Think of your property as an excellent source of cash. Even if your mortgage is for 25 years, you start building equity from day 1. When you make it halfway to your mortgage, your equity looks more impressive. Making those extra payments on your mortgage equates to building more equity faster.
You reduce your amortization period – remember that when you make those scheduled payments, those payments go towards paying off the interest. The extra payments you make (those that are not scheduled by your lender) go straight into the principal. So by making those extra payments faithfully, you gradually whittle down not only your outstanding mortgage balance but you also shorten your amortization period.
We’ll give you a real life example: a friend we know purchased a home that was worth $159,000.00. She chose to do weekly instead of monthly payments. Most financial lenders will advise that taking the weekly route saves you a neat amount of interest because weekly payments carry an inherent mechanism of diminishing interest. She made two extra payments once a month equal to the mortgage payments and continued that practice for two years without fail. She also made an anniversary payment of $10,000.00 after year 1 of the mortgage. Somewhere along the line, she lost her job and stopped making extra payments and obviously could not make any more anniversary payments. In spite of that, however, when her four-year mortgage was up for renewal, she managed to reduce her amortization period from 21 years (which would have been the normal number of years left for a 25-year mortgage) to 16 years! And all because she made extra payments for years 1 and 2 and one lump sum payment.
The example above demonstrates that by making extra payments on your mortgage, you “lighten” your financial burden and chip away slowly at the mortgage amount. Perseverance and financial discipline have its rewards.
You become a good risk to lenders – we did say that equity is the operating principle in life. When you make extra payments on your mortgage, you build equity faster and it is that equity that makes you an attractive risk to bankers and lenders. We wrote in a separate article in Professor’s House that when you’re a homeowner, bankers begin chasing after you, offering you money at ridiculously low rates. We don’t think renters have that much of a privilege. You are a good risk because bankers know that should you default on a loan payment they can seize a tangible asset to compensate for their loss. That tangible asset is your piece of real estate.
Let’s say you have a few years left to your mortgage and you and your spouse now want to live in a smaller, compact condo in town as a preparatory step to retirement. You want to sell your house but you need to spruce it up by renovating the basement. Instead of spending $20,000 of your retirement savings for turning the basement into a winner, your banker will readily offer you $20,000.00 and possibly more, by establishing a HELOC (home equity line of credit) for you and your spouse. Most financial institutions – at least in Canada - are willing to establish HELOCs for as high as 75% of the value of your house.
We’re sure there are other good reasons for making extra payments on a mortgage but the ones we discussed are the top three that we can think of. Imagine the possibilities that open up with a home equity line of credit: you can renovate, take a swing around the world, pay for a son’s or daughter’s education (or wedding), take up hobbies and courses, or retire “partially” in a dream vacation spot – maybe somewhere warm and tropical – so you don’t have to shovel snow and wear those atrocious down feather coats and mittens ever again!