20 September 2004
"I have been advised that I can cut the
life of my mortgage in half by making an extra payment to principal each month
equal to that month�s principal payment. Is this true?"
I have been asked this question many times
and have always answered it in the same way. "No, it isn�t true, because your
extra payments are too small in the early years."
Only recently did I decide to actually test
the idea that doubling the amortization would halve the life of a mortgage.
Using an extra payment spreadsheet from my web site, I assumed a 15year loan at
6%, and made extra principal payments equal to the principal portion of the
monthly payment.
I quickly realized that there are two ways
this can be done. One way is to make extra payments equal to the original
schedule of principal payments. When I did it this way, the loan paid off in
100 months, not 90.
However, if I based the extra payments on an
actual schedule that reflects the impact of prior extra payments, payoff
occurred in 91 months � just a tad past the halfway mark.
Principal payments based on the original
amortization schedule assume no extra payments. In months 1 and 2, they are
$343.86 and $345.58. If I pay an extra $343.86 in month 1, however, the actual
principal payment for month 2 would be $ 347.30 rather than $345.58. The
additional payment of $343.86 in month 1 reduces the balance on which the
interest for month 2 is calculated, resulting in less interest and more
principal in month 2.
It thus appears that you can cut the
life of your mortgage in half, or almost in half, if you make extra payments to
principal, provided the extra payments equal the actual principal payments.
While the required amount has to be recalculated every month, this is easy to do
if you download the first of my extra payment spreadsheets, and update it every
month.
The merit in this approach is that you don�t
require anyone�s permission, and having a concrete goal such as cutting the life
of the loan in half is one way to discipline yourself to save.
The downside of the scheme is that you must
increase your savings every month over the previous month. For example, on my
$100,000 loan at 6% for 15 years, the required savings would rise from $344 in
month 1 to $833 in month 90. This might work well for some but for many if not
most borrowers, it would not.
Borrowers who want to cut the life of their
mortgage in half can do it in many ways. For example, the four savings plans
shown below would all pay off my $100,000 15year 6% mortgage in 90 months. They
are thus alternatives to the double amortization plan with its rising extra
payment.
*A flat additional monthly payment of
$539 starting in month 1.
*A flat additional quarterly payment of
$1624 starting in month 3.
*A flat additional annual payment of
$7021starting in month 12.
*A combination of flat additional
payments of $300 a month starting month 1, and $3,000 a year starting month
6.
The four plans were derived from my
calculators 2a and 2c, which you can use to develop your own plan. It should
meet your own goals, which might be more or less ambitious than shortening the
mortgage term by half. And it should be based on a realistic appraisal of the
amount and timing of the savings you will be able to generate.
"Am I better off saving my surplus income, or
using it to pay down the balance of my mortgage faster?"
Extra payments to principal constitute
savings, just as adding to a savings account is savings. Both increase your
wealth. The only difference is that when you save in the bank, your wealth
increases through an increase in assets, whereas when you save by repaying your
mortgage, your wealth increases through a decline in debt. At the same interest
rate, the increase in wealth is the same.
For example, if you put $100 a month in a
savings account that paid 6% compounded monthly, after 5 years you would have
$6977 in the account. If instead, you have a 6% mortgage and you make extra
payments of $100 a month for 5 years, your balance declines by $6977 more than
it would have without the extra payments. In reality, of course, savings
accounts don�t pay 6%, which makes mortgage repayment a more attractive way to
save.
Copyright Jack Guttentag 2004
