September 12, 2018 by Greg
Today is my wife’s birthday! Since it’s her birthday, I want to talk about a topic where she’s been right and I’ve been stubbornly ignorant for too long.
Since forever ago, I’ve always just assumed that a mortgage is something you have to deal with. It’s a recurring payment and you do it each month and that’s that. A normal 30 year term is long enough to seem so far in the future that it doesn’t really matter to you right now. It’s a problem you can push off to your future self.
I think this is intentional on the part of banks and loan companies, but not in any kind of insidious or underhanded way. Rather, banks are simply in existence to make money. And the system we use in this country, the fractional reserve system, is specifically designed to put money to work. All that money that banks loan out for cars, mortgages, credit cards, etc.. it comes from the bank’s depositors#1. They’re only required to keep a certain percentage of the balance of your account available at any time. So if you have $1,000 in your savings account, the bank is only required to keep around $200. The rest it loans out, so the money can go do some work.
So the money goes out and does some work. And the more money, the longer it has to work. A normal car loan is 5 years. A normal mortgage is 30. Since these are the largest assets most of us will ever buy, it’s good that we have a system that allows us to get there.
But then you start looking at amortization tables. That money really does a lot of work. On a $300,000 mortgage at 4.5%, you’ll pay $247,220 in interest over a 30-year period. That’s almost double the original note, and this is at today’s historically low rates! My parents first mortgage was at 11%, which would equate to $728,000 in interest!
This is where I should start listening to my wife. I, and most of us, treat a mortgage payment effectively like a rent payment: it’s just a recurring chunk of money that goes out the door. But we need to start looking and thinking more about the principal amount and the reason we have the loan in the first place.
If you want to own a home, a mortgage is inevitable. But there’s a couple of ways to start making the loan work for you rather than work for the bank. The main goal is to reduce the number of years you have the mortgage sitting out there. Take a look at any amortization table and the first thing you’ll notice is that the interest is massively frontloaded. The first few payments you make are almost entirely interest and hardly any principal. What this means is that things you do at the beginning of a mortgage can have a massive effect.
The first thing you can do is drop length of the loan. We did this a couple years ago on our primary residence, moving from a 30-year note to a 20-year note with a lower interest rate. That single move saved us something like $200,000 in interest in the coming years. And, perhaps more importantly, it eliminated ten years of future mortgage payments that we would be tied to making.
Interest rates matter. Right now they’re finally going up after years of incredibly low rates. Do some math to see if it’s worth taking a point on a mortgage. For example, on our theoretical $300,000 mortgage, paying a point (1% or $3,000) now to drop the interest rate from 4.5% to 4.0% saves about $30,000 over the life of the loan.
Finally, and most importantly, look at principal payments. This is what my wife kept saying and I kept ignoring. There’s two ways to do this. First, pay a little extra every month. The normal monthly payment for a $300,000 note at 4.5% is $1,520. Add just $150 to that each month, and you take FIVE YEARS off your thirty year term!
The other way to go is to make large lump sum payments when you can, which is what we just did on the beach house. We’ve already taken off almost five years of mortgage. I can’t tell you how good that feels! The earlier these are in the mortgage, the more effect they’ll have on the interest you save. If you made a $10,000 payment to the principal just one year into your mortgage, not only will you eliminate two years of your mortgage, you also save yourself $25,000 in interest. Not a bad return.
Our plan is to keep making big principal payments on the beach house when we can. We’re also overpaying the mortgage a little bit as well. One mortgage is tough enough, so we’re very eager to not have two.
If you do decide to make any large principal payments, make sure you discuss it with your bank or mortgage holder. You actually have to set it up and specify that an out of cycle payment is for the principal, otherwise the bank can assume it’s just a future payment load and pay down your interest instead. Definitely not what you want.
I mentioned amortization tables earlier. While they’re boring, it’s really worth looking to understand the changes that can be made. Someone conveniently made a Google Sheet that lets you calculate the effect that principal payments can have on the interest and the term. I’ve used this to figure out just how quickly we can pay off the beach house and it opened my eyes!
You were right, Maureen. You were right.
1. It’s actually quite a lot more complicated than that, and there’s important differences between commercial banks and central banks and how the Money Multiplier Effect works.