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Thursday, December 29, 2011

A different way of thinking about paying off your house

For most people these days renting is a better financial decision than buying, but there are still many of us who do have mortgages.

If you're interested in financial independence, which I am, then the plan has to be paying off any debts as quickly as possible, mortgage included.

For normal debts, I recommend following Dave Ramsey's 'debt snowball' system until you have nothing left but the home loan. Then it's time to pay off the house, too.

But what is the best way to do it? Conventional wisdom on paying off mortgages early just says to add as much extra to your monthly payment as you can afford, and put it towards the loan principal.

This will certainly get your house paid off sooner, but paying extra on a normal mortgage isn't going to affect anything other than the pay off date. It won't lower your monthly payment, or change the interest rate. By itself this isn't a necessarily a big deal, but part of my all-encompassing plan for wealth, freedom, and financial independence is well, freedom.

One of the best ways to have freedom is to be financially independent, but I haven't gotten there yet. Second best is to at least have a chunk of savings that mitigates risks and keeps you from being a total slave to your job or current income source. This is especially important in today's economic climate, where you have to accept job loss as a very real possibility.

So putting a huge chunk of change towards your mortgage every month doesn't seem like the best idea, because you can't get to it in the event of an actual emergency.

So what about an alternative plan: Taking the money that I would put towards extra mortgage payments and just add to my savings? If you are putting some effort into intelligent investing you should be able to beat the modest percentage that you are paying on your home loan, which will magnify the effect as well. When your savings reach a point when you can pay off your house loan and still have enough savings for a well stocked emergency fund (no less than 6 months of expenses) then you can pay off the loan. So you should come out ahead at the end of an equal time period, right?

It depends. Most home loans are structured so that the majority of your payment for the beginning years of the loan go almost all towards interest. Very little is going towards reducing the principle. So extra principal during this time makes a bigger than expected difference in the payoff date and total interest paid. The difference isn't huge, but it is such that you will probably end up paying a little more if you do it by holding the money aside instead of the conventional extra payments.

So you need to do the math, and evaluate your risk tolerance . I would personally prefer to have $50K sitting there and owe $100K on the house, than to owe $50K on the house and have no savings. But maybe you want to split the difference, its up to you. Just make sure you do the calculations and make an informed decision.

-The Money Monk

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