Should I pay extra on my mortgage?

Question: In your column on Dec. 17th about adding extra principal to a mortgage payment, you almost answered a question I have long wondered about, but would like you to expand upon.

I paid a mortgage on my last home for 16 years. I’ve been paying on my current home for 31/2 years, all with no extra principal. Without a crystal ball I would guess I will continue to live here another couple years. I cannot envision staying longer than 10 years, but who knows? These are 30-year fixed mortgages.

The question: would I have benefited from paying extra principal, having sold half way through the contract; or assuming I sell my home in the first 10 years? Is there a general rule of thumb for short-timers, as most of us are? If it matters, I’m 62 years old.

R.B., Everett

Answer: You are correct, the average American moves every seven years, so very few people actually hold a 30-year mortgage for the full term. Even if they don’t move, many people will end up refinancing into a new mortgage at some point in time during their ownership.

So does it really make sense to pre-pay the principal on your home mortgage if you don’t plan to keep the loan for the full term?

It depends on your personal risk tolerance level and your financial goals and needs.

I’ll be honest: Owning my home free and clear has never been a goal of mine. I don’t mind carrying a mortgage for the rest of my life because I figure I can make more money investing the cash that would have gone into the extra principal payments. But that’s just me. I have a higher financial risk tolerance level than many people.

Other people like the freedom and peace of mind that comes with owning their home free and clear of any mortgage.

There is no right answer; it is a personal decision.

As I said in my previous column, the biggest savings from paying off a mortgage early come after the loan is gone because you then have all that extra cash in your pocket each month instead of sending it to the lender.

But you do save money by pre-paying principal and selling in a few years, just not as much.

Here’s an example: Let’s assume that you buy a home with a 30-year fixed rate mortgage of $250,000 and an interest rate of 5.5 percent. The mortgage payment (not including taxes and insurance) would be $1,419 per month. If you chose to pay an extra $300 per month to pre-pay the principal, you would pay off the entire loan almost 10 years early and save more than $98,000 in interest expense.

Now, if you sell your home after five years instead of keeping it for 30, here is what happens under the above scenario: At the end of five years, you will have paid a total of $63,655 in interest expense compared with $66,320 under the normal 30-year amortization table. That means you saved $2,665 in interest. But remember, to do this you paid an extra $300 per month for five years, a total of $18,000. So let’s look at the difference in the principal balance. By pre-paying $300 per month, you would owe $210,487 at the end of five years, compared with the $231,151 principal balance you would have owed under the normal 30-year amortization table.

That’s a difference of $20,664.

So the total return on your $300 per month investment looks like this. You saved $2,665 in interest expense and reduced the principal balance of the loan by an extra $20,664 for a total of $23,329. Your total investment was $18,000 ($300 times 60 months). So your net profit is $5,329 ($23,329 minus $18,000), which is a total return of 29 percent on your $18,000 investment over five years.

If that sounds like a good deal to you, then it makes sense to prepay the principal on your mortgage, even over a five-year period. If you can make a better return investing that extra $300 per month in the stock market or your business, then you would be better off keeping the money instead of using it to pay down your mortgage.

As I said above, this is a personal decision based on your financial needs and goals. I hope this helps you make a decision.

Mail questions to Steve Tytler, The Herald, P.O. Box, Everett, WA 98206. Fax questions to Tytler at 425-339-3435 or e-mail him at economy@heraldnet.com.