Over pay on a mortgage?

Question

On your own personal mortgage (or rentals) do you may more that what is asked? I have all my friend that pay $100 or over the dollar amount required when their mortgage. Do you do this? If so, why? If not, why?

Thanks for your help!

Joe Splitrock · Answer

@Victoria Radcliff we made extra monthly principal payments on our first home, but the interest rate at that time was over 8%. Paying extra principal will result in paying overall less interest and paying the loan off early. That sounds great in theory, but that doesn't take into account the opportunity cost of money. In your example, you are paying an extra $1200 per year. That money could be invested in other places, so you may be avoiding interest payments in the future, but you are also losing opportunity to invest today. You may avoid 3% interest, but you could have invested that money to get 10% or better returns.

One important concept to understand is that todays dollars are worth more than future dollars due to inflation. When I say worth less, I am referring to purchase power. Inflation makes a dollar have less purchase power over time. It averages to around 2.5% less per year. For example, to purchase a $100 item today, you will need $210 in 30 years. In other words in 30 years, the dollar is worth less than half what it is today. This is one good reason to not pay down mortgages. When you are making your last payments in year 29, you are paying off your loan with dollars that are worth half what they are today.

Todays historically low interest rates are near inflation rates. You can get an owner occupied loan for under $2.9% locked for 30 years. When you figure average inflation is 2.5%, this loan is barely tracking inflation. On a rental property you can claim interest as an expense, which means it reduces your taxable income. You may get 20% of that interest paid back in taxes, so that reduces your effective interest rate by another 20%.

Todays interest rates are basically free money. That is before you consider the opportunity cost of your cash. Paying down a mortgage early is an emotional decision, not a math decision.

Joe Villeneuve · Answer

Anything that comes out of your pocket, meaning the source of the cash comes from you, is a cost to you.  Anything that comes from someone else, as in the tenant's rent, is free to you.  When you are substituting your cash for the tenant's cash, you are paying for something that you were getting for free.

Also, when you are adding the extra $100 upfront each month, that negative $100 offsets $100/month from the cash flow.  Paying $100 extra/month might nock off the last 10 years at best, but that means you will have unnecessarily paid an additional $24,000 in accumulated $100 extra payments over the course of those 20 years of payments.  The interest isn't divided evenly per month.  The interest is heavily front loaded into the first year and slowly reduced the following years, so the interest you are reducing are from the end months...where the interest was at its smallest per month.

So you are paying heavily upfront, with money that could have been invested instead, for something that has a long time in the future hoped for savings (that isn't real), that was already being paid for you by the tenant.

Suzanne Player · Answer

If you do this, you're saving on the interest you would have paid on that extra $100 - but interest rates are low and you may be able to get a better return elsewhere.  Meaning, when you prepay a mortgage with a 2% interest rate, all you get is a 2% return on that money.  If you had an unusual loan carrying a higher interest rate like 10% (hard money, or a bad credit loan), then it would make more of a difference (provided there isn't a prepayment penalty clause in your mortgage).

If you goal is to pay off the mortgage faster, then you can use an online calculator and play with the variables to see how much extra you would have to pay to get the mortgage paid off in X years.  (Google "mortgage calculator" for a simple one.)

I think Brandon Turner has mentioned doing this on some of the Bigger Pockets podcasts.  He bought a rental house for his daughter when she was born, took a 30 year mortgage, then calculated what the (principal & interest) payments would be on an 18 year schedule.  When she's 18 she'll own it outright.  This can be done to pay for college costs as well.

My question is always, what would you do with the extra money otherwise?  If you're saving to buy another property, then it's delaying that process in order to pay off the one you have now sooner.  The right decision will be in line with your goals.

Joe Villeneuve · Answer

You're saving interest on your own home, but all you're doing on a rental is paying more money for the property.  The tenant is already paying that mortgage and interest for you.  Don't mistake the total cost for your cost.  They are not the same.

Tyler Bobo · Answer

I do not pay extra. It “saves” very little, and I can invest and beat that by many times over.  Makes more sense when interest is higher or for people at different stages of their life that it’s not worth the effort to reinvest elsewhere. Or just for the peace of mine to have their Mortgage paid off earlier.

Joe Splitrock · Answer

Something else worth understanding is the difference between saving interest on a fixed loan versus investing and getting compounding interest.

If I paid $100 down month one on a 30 year mortgage at 2.9%, I would save roughly $50 over 30 years, so I would net $150.

If I put $100 in a compounding investment (like a savings account) for 30 years at 2.9%, I would have $235 at the end of 30 years.

In fact if you invested $100 at 1.36%, you would end with $150 after 30 years. The point is saving interest is not the same as investing at a similar compounding rate. You want to put your dollar to work in a place where it compounds return.

Joe Villeneuve · Answer

You're not saving interest...you're buying it.

Joe Villeneuve · Answer

On the home you live in yes.  On a home you rent out, no.

Tim S. · Answer

That's true @Mary M. but you could take that cash, and rather than apply to the mortgage where you are only making the interest rate of the loan, you could invest it in something with a higher return, and after some period of time apply all of those gains to your mortgage in one lump sum.  If one doesn't have the skills or discipline to make more money outside of the mortgage, then ok, maybe you want to just pay down the mortgage.  It's not that hard to make 10% in the stock market (currently), so maybe you invest those additional mortgage payments in the S&P500, and every 3 years (for example), apply all of that to the mortgage.

John Morgan · Answer

@Victoria Radcliff

Save that money for a down payment for your next rental or invest it in the stock market. Never pay down your mortgage. Get more bang for your buck!

Over pay on a mortgage?

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