Should I prioritize my mortgage?

There are two schools of thought on this topic one is to pay down your mortgage faster and the other is to pay down slowly.

If your priority is to pay down your mortgage quickly there are several things that you can do. The most important thing are the changes that you can make to reduce your amortization period.

The amortization period is the length of time that it will take to pay off your mortgage completely. The most common amortization period is 25 years. This is not to be confused with the mortgage term. The mortgage term is the length of your current contract with the bank which usually happens in 5 year increments. In other words, if you get a brand new mortgage, you will usually need 5 terms before it is paid off (provided that you don’t refinance and that the rate and payments stay the same which almost never happens).

Some tricks to reduce the amortization period of your mortgage:

1. Make accelerated payments. When you accelerate your payments (weekly or biweekly), you are essentially making more payments per year on your mortgage thereby paying it off more quickly and reducing the amortization period. For example, if your monthly mortgage payments are set to $1000/mth, then you will pay a total of $12,000 in one year. If you accelerate those payments to biweekly, you will make $500 payments ($1000/2) every 2 weeks. But there are 52 weeks in a year so that means 26x$500 payments = $13,000 in one year. So as you can see, by switching your mortgage payments from monthly to biweekly accelerated, you have paid $1000 more (which is like an extra monthly payment). So every year, you have made the equivalent of an extra monthly payment. This will reduce the length of your mortgage by years (commonly 2-3 years so you paid it off in 22-23 years instead of 25 just by making that one little change).
2. Reduce your amortization period. When you set up your mortgage for the first time, you can dictate the amortization period. The shorter the amortization period, the higher the payments. But be careful! If you are too aggressive and set the amortization period short, you can’t extend it again UNLESS your mortgage term matures OR you break your mortgage, in which case you will be subject to a penalty. For example, if you set your amortization to 25 years and accelerate the payments or increase the payments, you can always revert back to 25 years if your income drops. But if you set your amortization period to 15 or 20 years (resulting in much higher payments), you cannot extend it back to 25 years. So it is generally safer to set the amortization and payments to a comfortable level to start and then destroy the mortgage rather than set them to destroy the mortgage.
3. Use your prepayment privileges. When you sign a 5 year contract with the bank (which is the most common mortgage term length), your mortgage payment amounts are set. You cannot pay less or more than that without being penalized. However, there is an exception to that rule. Most mortgage lenders will provide you with something called prepayment privileges. What does this mean? This means that they will allow you to increase your payments and/or make lump sum payments on the mortgage, thereby, you guessed it, reducing the amortization period! But there is a limit. Why? Because the bank WANTS you to make the payments over a longer period of time (and as agreed in the contract), otherwise they will receive less interest. What are those limits? Good question! Usually the prepayment privileges are limited to 15/15 or 20/20. That means you can increase your payments by up to 15% per year, and you can make a lump sum payments of up to 15% per year, which is applied directly to the principle amount of the mortgage. Using your prepayment privileges is a VERY good way to reduce the amortization period because it gives you flexibility. If money is tight, you don’t use them. If you have extra cash, you use them. Unfortunately, most mortgagors do not take advantage of their prepayment privileges.

What is the other school of thought?

The other school of thought on how quickly you should pay off your mortgage is to never pay it off! But why would anyone not want to become mortgage-free? Isn’t it everyone’s goal to have a home with no mortgage. In short: no. This strategy may not be for the faint of heart, but we let the numbers do the talking. 🙂

What to do? Live mortgage-free or leverage?

Let’s say your mortgage term has matured, your balance is $200K and you won $200K in the lottery. You now have the choice to put $200K on the mortgage and be mortgage-free OR to renew and keep the cash. (Equivalently, we could rephrase this by saying that your home is mortgage-free and you need to decide if you would like to refinance it and extract $200K, thereby putting $200K in your pocket.)

Most people would immediately jump to paying off the mortgage completely (or NOT refinancing).

The question becomes: how much is that mortgage going to cost you vs. how much could you make off $200K if you were to invest it?

Cost

Let’s say the mortgage rate is 2%. So that $200K is costing you $4000/yr (not exactly but close enough, to keep the numbers simple).

Return on Investment

You might say that you could take that $200K and invest it in the stock market and make a 15% return. That’s a really good return! Wouldn’t it make sense to borrow at 2% and get 15% and pocket the difference? If your answer is yes, then maybe you’re convinced that it doesn’t make sense to pay off your mortgage and rather take that money and invest it elsewhere. But the nay sayers might point out that it’s very risky to expect a return of >2%! And they are right! You could lose money on the stock market! So does that mean that we are back to playing it safe. Not so fast. Thankfully, the stock market is not the only way to invest. You could buy a rental. Ok – what does that look like?

Invest in Real Estate?

You take the $200K, use it as a down payment on a $500K home and rent it out. So now you are borrowing $300K at 2% (assuming you won the $200K in the lottery). So it’s costing you ~$6000/yr. Assuming property taxes are $300/mth and insurance is $150/mth, total expenses are $6450/year. If you rent it for $2500/mth, that’s $30K/yr rental income. Net return on the $200K is $24K. That’s a 12% return on your investment. What’s more is that does not include the appreciation of the property!

Conclusion:

You can pay off your mortgage and save the current mortgage rate OR you can leverage your home and make the difference between the cost of borrowing and the return on your investment. Just make sure you use the money wisely if you’re borrowing it! The plan falls apart if you go and spend it on a yacht. 😉