The desire of most if not all homeowners, is to repay their mortgage loan within the shortest possible time, cash flows permitting. Psychologically, in the best case, we would prefer not to have any debt at all. There is a sense of satisfaction and comfort in not having the obligation and burden of the impact of default.
A recent study in the United States suggests that more than $1.5 billion is spent annually on accelerating mortgage payments. Interestingly, the study found that 38% of those persons making extra payments on their mortgage were “making the wrong choice.” The study noted that these persons would have gained a much better return on their money by investing in either their Company’s retirement plan or some other form of retirement savings.
One commentator remarked on the findings of this study, “that it underestimates how many people make a mistake by prepaying their mortgages” while either carrying higher rate debt, or failing to make adequate provisions for emergency and/or retirement savings.
There is no doubt as to the savings that can be derived from prepaying a mortgage loan. Some examples will illustrate this position.
Assume a 30 year mortgage on $500,000.00 at an interest rate of 8% per annum, and monthly installment of $3,668.82. Total interest to be paid over the life of the facility would be approximately $820,000.00.
- An additional monthly payment of $100.00 could yield a saving in interest of approximately $96,000.00 and reduce the repayment term by just over 3 years.
- An additional monthly payment of $250.00 could yield a saving in interest of approximately $200,000.00 and reduce the repayment term by approximately 6 years.
- An additional monthly payment of $500.00 could yield a saving in interest of approximately $300,000.00 and reduce the repayment term by approximately 10 years.
Many homeowners would find this potential for saving on interest and repaying the mortgage in a shorter time to be attractive, more-so now that the tax benefit/deduction on mortgage interest paid is no longer available.
It is by no means being proposed, that home-owners should not make prepayments to their mortgage when and where such an opportunity arises. However, when deciding to invest surplus funds, consideration should be given as to whether this option would in fact yield the best return and/or savings over the long term.
Currently a residential mortgage still provides the best interest rate that can be sourced on the market. Notwithstanding increasing interest rates, the rates currently paid on mortgage loans are still less expensive when compared with most other loans, with the prime lending rate currently at 11.75%.
Therefore, in determining whether a prepayment of mortgage is advisable, other alternatives/priorities must also be considered.
Retirement savings
Increased contributions to retirement savings should be a primary consideration for the investment of surplus funds. In addition to the financial security that is derived in the long term, this option also offers the possibility of reduced taxation, as the contributions payable toward most pension plans and annuity type investments are tax deductible.
Debt repayment/consolidation
In determining whether debt is to be repaid, interest rates on all debts must be considered. It is more likely than not that other forms of financing are accruing interest at a higher rate than that which applies on a residential mortgage loan. This would be particularly true for credit card debt. A greater saving is therefore realized by reducing or eliminating your credit card debts at approximately 24% per annum interest rates, rather than prepaying an 8% mortgage loan.
Financial flexibility
It is estimated that fewer than three in ten households have enough savings to withstand three months unemployment or other emergencies. Indeed many of these households live paycheck to paycheck. Financial planners advise that you should now have the equivalent of at least six months of your monthly expenses available in savings to meet any emergencies that may arise.
Having such an emergency fund, coupled with access to a home equity line of credit can provide the financial flexibility that makes the difference between surviving a ‘rough patch’ and financial disaster. This should therefore be a priority use for your surplus funds, after saving for retirement and repaying high-interest debt.
There is also one much more subjective consideration, and that is, “living a little.”
The ideal is that there must be a balance between saving for tomorrow and living today. The person who is so set on repaying a mortgage in as few years as possible, even if it means skipping family vacations or the occasional dinner is just as out of balance as the person living on credit cards.
A realistic goal therefore, regarding the repayment of mortgage debt would be to ensure that it is repaid by retirement. As indicated earlier, while prepayment presents an opportunity for interest savings, it must be considered in the context of other goals and life interests. This would serve to make the home ownership experience, one that is truly rewarding.
Submitted to: The Editor – Business Guardian
By: Gillian C. Caesar, General Manager – Mortgage Services
Trinidad and Tobago Mortgage Finance Company Limited