I love this question!
Why? Because this was me – when I was 23 and self-employed I bought my first home and was of the mindset to pay off my home as soon as possible. I went further and took out an actual 15 year fixed mortgage figuring I better force myself to so this.
This mindset could have cost me $100,000s.
There are emotional reasons and logical economic reasons to prepay a mortgage or not. The decision also depends on your personal finances and goals.
I thought the best way to secure my old age financial security (yes I was that conservative or worried at 23) is to quickly pay off my largest debt which was the house. I did this for about 3 years paying it down at a 10 year pace, until an opportunity came up to buy another property and I didn’t have enough savings.
It was a FSBO (for sale by owner), who was not on the market through the MLS, they were an out-of-state owner selling a little house near the beach, here in a suburb of Los Angeles. I knew I had to act quickly, and realized I didn’t have enough savings. I also realized that the money I had paid in “extra” principal with was ½ the down payment ($20,000).
So I quickly refinanced the house to a new 30 year loan and decided then that I would never again chance missing out on an opportunity like that again.
That house now is worth $900,000 (I bought it for my sister and she sold it). Imagine if I couldn’t come up with the $40,000 or if I couldn’t refinance fast enough, I would have missed out on a gain of $700,000 over the last 20 years because I couldn’t find the $40,000 *20% down on that $200,000 house). We call this Opportunity Cost of financial decisions.
Hindsight shows us the lessons with clarity so I hope my past journey helps you see your future.
Let’s start with the dollars we are talking about…
On a typical $240,000 loan at today’s rates of 3.375% 30 year fixed your payment would be $1061.03 which starts with $675 in interest and $386.03 in principal. Every month of course there is more principal and less interest in the payment.
If you were to pay that same loan off in 15 years, you would add almost $650 per month ($639.99 to be exact) to do it for a total payment EVERY month of $1701.02 (don’t skip a month cause then it won’t be paid in 15 years).
- Following this plan, in 15 years will you have
- no mortgage debt – good,
- No interest write off – maybe ok,
But $639.99 x 180 payments $115,198.20 was tied up here instead of working for you.
What could you have done with that money?
Depending on how old you are, you might need that cash for something else that is an urgent need or just a better deployment of these hard earned dollars.
This better be above and beyond regular savings, not your last cash flow dollar every month either. You may have cash needs for the property itself, so save up for that first. Depending on where you live a roof can be $2000 to $50,000, what about maintenance? Hopefully you don’t have a pool as the repairs and replacement can be a lot…
So, I am assuming that this money is above and beyond these, that there is already savings for emergencies and repairs and old age security.
The cost of living: In Los Angeles the CPI was 3.3% in July (you can look up your region by going the http://LBS.gov to see the inflation rate as measured by the CPI in your area).
The real cost of Money: So you can borrow at 3.3% and the inflation is 3.35% (or maybe 2.1% in your region).
They are giving you free money and you want to give it back? And quickly?
Trapped money: If you give back the money through making extra payments and you need money, the only way to get it back is to borrow and almost certainly it will be at a higher rate. We call this illiquidity. You need liquidity, savings or some other form of cash.
Real estate is illiquid so you took a flowing asset and locked them in an illiquid asset.
How $639.99 per month becomes $225,183…
Time value of money: That $7679 in cash that you were going to add to principle per year could grow to be $225,183 by investing that amount earning 8% and adding the next $7679 and getting 8% (compounded annually) … over 15 years.
So 1) save the money, 2) earn interest, 3) let it grow exponentially, then in 15 years if you feel you “have to”, out of this bigger pile of money, you can pay off the $149,702 still owed on the mortgage and have $75,000 + left over to play with or maybe it will be NEEDED. And what if you could make more than 8%?
Your future self will thank you for growing your hard earned dollars not locking them away.
CA DRE 01142629