One very effective, but often overlooked way of saving money is increasing your monthly mortgage payments.
The idea of spending money in order to save sounds like a contradiction, but if you look at your bigger financial picture it makes a lot of sense. Here’s why:
Remove all obstacles in your path
When you play chess, your main objective is to checkmate your opponent. To achieve your goal, you need to find strategies and tactics for removing those obstacles so that you can move forward. Occasionally you might even have to sacrifice a valuable piece to get ahead. In the short term, sacrificing a piece may not seem advantageous, but in the long term a sacrifice may help you win the game.
Similarly, in personal finance, you need to eliminate the debts blocking your path towards a comfortable retirement. These debts include credit card balances, bank overdrafts, and also your mortgage. By making larger monthly payments, you can pay off your mortgage more quickly.
You actually end up spending more money over the long term if your monthly payments are smaller and the mortgage is spread out over a longer duration. But why is this, if you are borrowing a specific sum of money in both cases? The answer lies in the way that a mortgage is usually built.
How does a mortgage work?
A mortgage is a loan you pay to the bank with your house as collateral. In America, mortgages usually vary from 10 years to as long as 50 years. The debt that you pay back consists of the principal, or the actual sum that you borrowed, plus interest. Due to compound interest, the amount you spend on interest payments will grow over the years. There are various types of mortgages, including fixed or variable interest mortgages, flexible mortgages, mortgages for a certain percentage of value of the property, and more.
Many borrowers think it’s easier to spread their mortgage over many years so that the monthly payments are smaller. However, the longer the mortgage is spread out, the more interest you have to pay. Be aware that a larger percentage of the money paid back to the bank goes to paying interest costs, not principal. If you take a very detailed look at your mortgage statement, you will see that sometimes your monthly payment covered far more interest than principal, barely reducing the value of the debt!
What you need to consider when increasing your mortgage payments
If you decide to shorten the length of your mortgage by increasing the payments, be aware of the following:
- Many banks charge a penalty for paying off a mortgage early because they will lose future interest payments. Therefore, when making your final decision, find out how much this penalty is and include it in your calculations. When you look at the overall figure, you may be surprised to see that even including penalty payments, you’ll still end up paying less money keeping the original terms.
- When deciding how much to increase your payment levels, look at your overall financial picture. You should only raise your payments to a level that you can actually afford. If your monthly payments are too high, you may end up defaulting on them, which could cause you to lose your home!
Do you still want to have a mortgage when you retire?
Another reason for paying off your mortgage early is to be free of mortgage payments by the time you retire. Why is this important? When you retire, your pension payments become your steady income, and are typically only a fraction of what your paycheck was. This may make it harder to find the money to meet the mortgage payments. If you pay off your mortgage before you retire, you can then enjoy your golden years without the pressure of making monthly mortgage payments while you are living on a pension.
For more about paying off your mortgage early, read this.
Douglas Goldstein, co-author of Rich As A King: How the Wisdom of Chess Can Make You a Grandmaster of Investing, is an avid chess fan, international investment advisor and Certified Financial Planner (CFP®).