This is a really tough topic to discuss and most homeowners are very passionate about their response. When this topic surfaces at a party you can watch the financial peace shatter as both sides refuse to even consider the opposing viewpoint.
Today we are going to consider the advantages and disadvantages of making extra principle payments, refinancing to a shorter term, and prepaying the loan in full. It is your responsibility to make the best possible choice for your family circumstances. You must properly research all choices, taking short cuts and simply following the crowd is unacceptable.
Jim Lilley is an advisor at Chesser Financial and teaches “How Money Works” seminars to consumers and financial professionals.To listen or download use following link: Jim Lilley of Chesser Financial.
The main consideration is opportunity cost, money is a limited resource and once spent is no longer available to use again. Start by creating a detailed statement of cashflow. List all net income, including jobs, self-employed, net rents, etc. and all monthly expenses and debt. Initially use the minimum required payments for all debts. Include utilities, cell phone bill, gym membership, groceries, entertainment and any other regular expenses. How much is left after all bills are paid? This figure is what can be used to save, payoff debt, and use for non scheduled expenses.
Next write down all assets, and this would include anything of value that could be sold. Stocks, bonds, retirement accounts,life insurance, coin collections, real estate equity etc. Now list all liabilities, debts you owe and include the name, current balance and interest rate. For credit card accounts pay attention to history. How long have you been carrying a balance? Has the total owed been going up, down or staying about the same? What was purchased? Groceries, emergency car repairs, vacations etc?It is critical to understand the why behind the debt so destructive patterns can be modified.
You can find free resources to help you at Mint.com. Now take some time and write down major anticipated expenses, including auto repairs and purchases, home repairs and purchases, college and vacation expenses etc. Determine the estimated amount and date you will need these funds. For each one take the amount needed and divide by the number of months until the event. This will give you the monthly contribution needed to prepare for these future expenses.This assumes a 0% rate of return so your savings will grow faster than budgeted and this is a good thing. Other factors to consider are retirement plans and life insurance needs.
The priority order for monthly cash flow is:
- Pay current living expenses.
- Pay all bills due using minimum payments.
- Establish a 3-6 Month Emergency Fund.All extra money goes here till goal is met.
- Pay the monthly allocation to major expense categories.
- Use 75% of excess monthly cash flow to pay unsecured debt.25% into an investment account.Continue till unsecured debt paid.
- Make minimum required payments on installment loans, mortgages and student loans. Possible exception if high interest rate.
Once credit card debt is paid in full be very careful to not carry a balance ever again. Use credit cards for convenience, safety and potential bonus savings only if you are confident of your ability to pay off monthly. Next :
- Focus 100% excess monthly cash flow into investments to prepare for life events.
- Make minimum required payments on installment loans, mortgages and student loans.
Once you are satisfied with investment balances and preparedness for future you can once again evaluate options:
- Paying down/ Paying off mortgage. Mortgage terms are spread over 15-20-30 years so paying off early can save tens of thousands of dollars of interest. Mortgage rates are usually fixed and very low (currently 30 year fixed rate is below 4%). In addition many Americans can deduct the mortgage interest on their taxes. Still an intense satisfaction comes from making the final mortgage payment owning your home free and clear.
- Continuing to fund investment accounts and maintain minimum payment on mortgage. For most Americans this is the best and safest option. Here’s why?
- Extra payments on mortgage only reduce monthly responsibility once it is paid in full. So taking out a fifteen year mortgage and sending in two full payments each month for five years would still leave the homeowner owing full monthly payments, even if they were to lose their job, become ill or face other tragedy.
- If the borrower took out a 30 year loan, and those same extra dollars were captured and put into an investment account, liquid cash could be withdrawn as needed to make monthly mortgage payments and pay other expense.
- The equity in our home is not like cash and is often not accessible when we really need it. Accessing home equity requires borrowing against or selling the home.
- Fixed interest rates allow us to lock in the lowest rates in history. The future rate of return on our investment account is variable and odds are in our favor to earn a much higher rate then we are paying.Let me be clear that preservation of principle is more important than taking on unnecessary risk chasing high rates of return.
- The American homeowner is far too stupid to save and forcing them to make higher mortgage payments is the only way to guarantee they will not waste the money by mindlessly purchasing luxury items. This is the same argument for maximum funding a company sponsored 401k even if the overall investment performance is less than zero.