There has been a lot of debate on a number of blogs lately as to whether it makes financial sense to make extra mortgage payments or not. As someone who does make extra mortgage payments – I thought I’d jump in and share my thoughts on the matter. Please note that I’m going to speak about this issue from the Canadian perspective. While some of the points hold true for other countries, there are some significant tax impacts that citizens of the US and other places need to consider.
To start, I’m going to leave aside the philosophical considerations and just focus on the math. When people talk about extra mortgage payments – they are usually talking about one of two things: extra principal payments, or the extra payment of an accelerated payment frequency.
Extra Mortgage Payments (Prepayments)
Mortgage prepayments are those additional payments you make against the principal of your mortgage over and above your regular payment. If you check the fine print of your mortgage documents, most financial institutions (FIs) will allow extra payments of up to 10% of your outstanding mortgage principal per year. Some FIs will only allow you to make this payment on the anniversary date of your mortgage. I deal at a credit union and not only can I make prepayments at anytime – but they also allow prepayments of up to 20%! (Yet another reason I love my credit union)
Okay let’s look at the math:
Let’s say I have a $300,000 dollar mortgage, amortized over 25 years at 4%. Let’s say I make monthly mortgage payments and I want to compare the impact on the total debt costs and length of amortization if I make an extra payment of $200 per month.
|No Prepayments||With Prepayments|
|Total Monthly Payment||$1,578.06||$1,778.06|
|Amortization Length||25 years||20 years and 8 months|
|Total Interest Costs||$173,418||$139,580|
(Calculations made using: http://mortgageintelligence.ca/prebuilt/calculators-mi/CAMortgageLoan.html)
So by making an extra $200 a month principal payment – I’d save almost $34,000 in interest payments and knock over four and a half years off my amortization. Not bad.
Increasing the Frequency of Your Mortgage Payments
Making prepayments isn’t the only way to slash interest costs and amortization length. Even increasing the frequency of your mortgage payments can save you time and money. Rather than paying monthly, you could choose to pay your mortgage, bi-weekly, weekly, accelerated bi-weekly and accelerated weekly. What’s the difference between accelerated and non-accelerated? Well because we have 52 weeks or 26 bi-weekly periods in a year, paying a mortgage payment aligned to those time periods works out to one extra monthly payment. Accelerated payment schedules incorporate this extra payment where as non-accelerated essentially take the amount you would have paid with your monthly payments and divide it over the 26 bi-weeks or 52 weeks (so no extra payment included).
Let’s take a look at the same $300,000 mortgage but with accelerated by-weekly payments. Remember it’s amortized over 25 years at 4%.
|Regular Monthly Payments||Accelerated Bi-Weekly Payments|
|Total Payment||$1,578.06 (monthly)||$789.03 (bi-weekly)|
|Amortization Length||25 years||21 years and 11 months|
|Total Interest Costs||$173,418||$148,872|
Just by changing from monthly payments to accelerated bi-weekly payments – I’d be able to save almost $25,000 in interest costs and I’d knock over 3 years off my amortization. The savings would be even greater if we went to accelerated weekly payments.
Both of these mortgage repayment tactics work because mortgage interest is calculated daily. So by reducing the amount of outstanding principle by greater amounts more often – you’re reducing the amount of daily interest that accrues. It’s the power of compounding in reverse!
Sure, But Does It Make Financial Sense?
This is the more difficult question. The strongest argument against making extra mortgage payments is that you could make a better return on that money by investing it. There is a lot of truth to that. Let’s take a look:
Let’s take that $200 prepayment and compare it with a regular $200 investment into the market.
|Interest Rate||4% (mortgage cost savings)||9% (est. ROI)|
|Investment Period||20 years and 8 months||20 years and 8 months|
|Final Value||$33,838 (interest saved)||$94,924.08 (return only)|
So we see that by investing that $200 we get a return of almost $95,000. Note this number doesn’t include the principle (the cumulative amount of your $200 contributions) so that we can have a direct comparison. The mortgage prepayment final value doesn’t include the value of the $200 principle contributions to your home equity either.
So at first glance – investing seems to be the way to go because it produces a larger return. That is, until you factor in taxes and fluctuating mortgage rates.
Don’t forget, unless you invest it in a Tax Free Savings Account (TSFA) your investment return will be subject to income tax. Your mortgage interest savings is not taxable. Even if your investments are in an RRSP, the taxman will eventually cometh. You’ll have to give up a portion of your investment returns. The number of possible scenarios here is large so I won’t even attempt to calculate them – just keep in mind that your investment gains will not be as large as you’d like them (again, unless you’ve used the TFSA vehicle).
Here I’ve used a mortgage rate of 4% which is a bit higher than the going rate. Keep in mind that every few years you have to renegotiate your mortgage and that the higher the mortgage rate – the better the return prepayments achieve. Mortgage rates are now extremely low. I suspect that over time we’ll see them go up.
To be 100% transparent here, this back-of-an-envelope figuring is a really simplified view of the situation. What your marginal tax rate is, what investment types you choose, and whether the investments are registered or not all matter greatly. Another HUGE factor is the return you actually achieve in the market. If you make some poor choices, that 9% return could be much lower, even negative. Each family will have to figure this out for themselves, however a good rule of thumb is:
If you already max out your RRSP and TSFA savings and you are in a higher tax bracket, then extra mortgage payments MAY be a reasonable alternative to non-registered investments.
I Just Don’t Want to Make Mortgage Payments Anymore
The final point to consider is your happiness. This is the more philosophical argument. We’ve run through some simplified economics on this point – but in addition to the math, we must consider the heart. Financial value is one important measure, but the value we place on being debt free should also factor in. If security is really important to you, then paying off your mortgage faster may bring you greater levels of utility (to use that old economist’s term for joy) than the extra cash return you MAY receive. In the end, it’s a matter of personal choice. You must ask yourself, what will bring you greatest happiness and peace-of-mind?
For Jane and I – we do both. We make accelerated weekly payments (alternating pay cheques make this easy to manage) and we put an additional $100 per week on the mortgage. We also however, max out our RRSP and this year will finally max out our TSFAs. Our investments are almost entirely equity based, so the added security of extra mortgage payments provides a bit of balance and stability to our overall net worth.
Tell me – what do you do and why?
Photo credit: lendingmemo.com