So I just refinanced my mortgage, and my payment is $1711.35. My natural inclination is to set up an automatic payment of $1800. Is this wise or am I being a dumbass?
Well, before considering the economics, at least check to make sure that your mortgage allows overpayments, and automatically gives full credit for them.
Occasionally there is a penalty for prepayment but not on one I’ve ever had. I have only had two primary mortgages and two refis, so I am not familiar with all the types of mortgages out there. I have never heard of one that does not give credit for overpayments, but I have heard of penalties for early payoff. So I agree that you should check the terms of your mortgage first.
Then, assuming you can overpay your payments without penalty and the overpayment will be fully applied to principal, then you need to ask this:
What is the interest rate on your mortgage?
If you do not pay extra, what is your next best use of that money?
To determine this you need to compare the interest rate on your mortgage to any return you can get on investing that money (if you actually invest it). Many (most?) people don’t have a way to invest the money with a return that will beat their mortgage interest, but if you do, then do that instead. For example, if you are not maxing out your 401(k) or IRA contributions, you should do that instead of paying extra on your mortgage, if the long-term market returns will beat your mortgage rate.
However, if you would just spend that $88.65 a month on crap, then use it to pay your mortgage and it will pay you back in the long term.
If you do this be sure you inform the bank/mortgage holder that the extra payment is to be applied to principal. Some will just consider it an early and partial payment of the next month’s amount due.
When I had a mortgage, my bill always had a space that could be filled in if you wished to apply extra payments to the principal and/or interest. If your bill does that, it should not be a problem.
If the rules allow it – check to be sure, as said repeatedly above – then whether or not it’s “reasonable” will depend on the interest rate differentials.
Say you have a 200 dollar debt at 5%, and a 100 free cash you can put in savings at 2%. If you put the cash in savings, you get 2 bucks interest coming to you but then owe 10 dollars interest on the debt balance. So you’re minus 8 total on the deal. But suppose, given those interest rates, you’re allowed to apply all your free cash to the debt. Then you don’t get the interest from savings, sure, but your debt load is only 100 instead of 200 at a 5% pop, so you’re down to only minus 5 net interest payments. This is an improvement from the minus 8 it was earlier! So it’s a perfectly reasonable choice to pay down the debt early. You’re reducing your net interest burden.
Not always the case.
There was a pretty weird time in the early 1980s where a lot of people had fixed interest payments at a relatively low rate, at the same time that interest rates were exploding. So say you have the same 200 dollar debt at 5%, and 100 free cash you can put in savings bit this time at a much higher 10%. If you pay off the debt early, you’re again at minus 5 for the interest payment. But if you keep the cash an invest it, you get 10 bucks interest on your savings, at the same time that you’re paying 10 interest in the debt load, which equals out to zero. You’re better off not paying off the debt early! The error in paying shit off early was compounded by the high inflation rate: the real value of the nominal debt load was dwindling rapidly just from time running along. If you didn’t pay it back early, unexpected inflation would eat away most of your debt. It would be much easier paying off the future balance with the shitload of future dollars that were being printed up in excessive amounts.
A “rational” agent doing the simplest mathematical calculation would NOT pay off debt early in this case. Yet in the real world, a lot of people just really hate being in debt. And so plenty of people were paying down their debts ahead of schedule, despite the fact that they were pissing the money away. They would have been financially better off making the minimum payments.
It’s a wonderful idea as long as the extra amount will be credited to principal. Doesn’t look like much at first, but the drawdown and resulting interest savings over time can be considerable, and the cost, relatively painless. I once paid off a second mortgage years early by adding a dollar or two to each month’s payment. The bank loved me.
The bank would prefer eternally receiving interest payments from reliable borrowers.
They get no direct benefit to the principal being repaid early, except for the knowledge that you’re a highly reliable person, of the sort they’d like to be indebted to them again. The interest is their revenue. The early principal repayment reduces your interest burden, and therefore their revenue.
[Moderating]
This is asking for advice, with no one definitive right answer. That makes it a better fit for the IMHO forum than GQ. Moving.
Why would you be a dumbass?
Confirm with your bank that any overpayment would go to principal. My bank would apply any overages to late fees/missed payments first, then apply it to principal. Since I was never late or missed a payment, I was knocking down my principal pretty quickly.
However, during the bank implosions of 2008, my HELOC was through Washington Mutual, which got folded into Chase. It took me about six months of calling them and bitching them out every month because they were applying my extra payment to interest (the explanation was that was the agreement they had with Washington Mutual when they bought my loan, along with thousands of others.) I finally got it sorted out but make sure your bank is applying any extra payment the way you want it applied.
My payment is $1824.**. I have paid $1,850 with the 1st loan payment. NO problem. The bank put the extra to the principal.
A bank has to tread a fine line between getting interest now and getting continued interest. Someone who pays regularly is a prime candidate for new or additional loans; that’s what a credit score is all about. That is why a high credit score generates offers of more credit.
Banks don’t hate those who pay off loans early; they love them because such borrowers are likely to be good customers again. Maybe the bank doesn’t make 100% of all possible interest, but banks rarely do anyway. Few 30 year mortgage loans are paid for 30 years.
So my comment that “the bank loved me” for paying a little extra is a valid statement.
Anymore, at least in the U.S., the odds are fairly strong that the bank is merely acting as a loan servicer, and the bulk of the interest payments are actually going to whatever investor now owns the note. The bank therefore doesn’t care whether you pay off the loan early or not; they’ve already booked whatever profit they’re going to make on this loan.
Pay as much as you can afford. Its fun watching that balance plummet. I paid my chicken shack off in less than half the loan period.
Interest does not add value.
Thanks everybody!
I bundled in my credit card balances from health care and household appliances, so no other debt to pay off. I’m determined to keep it this way, as the refi was an attempt to get lowered monthly bills for retirement this year.
Without going into detail, we did the same thing. First loan was 30-years, and I paid $50 extra, later $100 extra, and later still $200 extra. At year 8 I refinanced to a 15-year loan.
In the end, we paid off the house in 12 total years. Starting early with extra payment is key.
This is very true.
I don’t see where anyone has said otherwise in this thread. But still, it’s true.
Okay?
As far as I can tell, every statement in your post is fully “valid”. I wouldn’t necessarily phrase things quite as you did, but it’s all solid stuff. And of course, I should be saying this since I said pretty much exactly the same things.
Yes, all of this is very valid and was well worth the repetition.
I didn’t say your bank doesn’t love you. You may keep the photo album in a prominent place. What I said was: The bank would prefer eternally receiving interest payments from reliable borrowers. That statement remains fully true. So sure, your bank loves you for being reliable and not defaulting. Not the way I’d personally phrase it, but it’s fine. I don’t want to denigrate their feelings for you. But I do want to clarify those feelings, at minimum for the others in the thread who do not know as much as banking if not for you personally. I’m afraid that they only love you like a cousin. Their feelings are genuine, yes, but not of the deepest variety. I used the word “prefer” advisedly. I meant it. I used the word “prefer” because it’s true.
You are not the one they fantasize about at night, alone in the darkness with their shades drawn and the covers pulled up. They are flushed and distracted, with someone else entirely on their mind.
Very true, all of this.
But it doesn’t change the underlying nature of the statement, just who the concepts apply to. For example, the shitty tranches of mortgage bonds* are exactly those that are repaid early. People refinance when rates drop, and the holders of those tranches get their money back early, at exactly the worst time when rates are low and there’s no other good place to put their money. The better tranches of the bonds are those that don’t get repaid as early, so that the holders can keep sucking down the interest payments longer. It’s exactly the same sort of idea, just within the structured finance environment.
*All of this presumes that there actually are good tranches and bad tranches, rather than the entire thing being just a big ole pile o’ shit. Which sometimes happens.
Want to re-iterate this.
Suppose you’re making the May mortgage payment. You send in twice the required amount. The bank will take that as the May and June payment. One month later you make a normal payment. The bank takes that as the July payment. If you only did this once, you pay off the mortgage one month early. But if it is made as a payment for principal, then the savings on interest result in a somewhat faster payoff.
You need to find out and follow their rules on extras going to principal.
If your mortgage doesn’t allow prepayment, you made a bad decision.
Probably not. Most banks don’t. It would be a mistake to assume the bank’s mind works logically as yours does. If you are wrong, and skip a payment, thinking that you covered it already, you will probably owe more interest and a penalty. Don’t assume anything.
You have to analyze what you would do with that money if you weren’t using to pay it off early. If you can invest it and get a return that is higher than the interest rate you pay on the loan, it is a no-brainer to invest it instead of paying the loan off early. It depends on your situation, and “pay as much as you can afford” is not one-size-fits-all advice.