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Make meaningful improvements to your finances every week.

Should I Overpay My Mortgage?

overpay-mortgage

I’m working on the final steps to close my Condo and I asked myself, “Should I Overpay My Mortgage?”  Right now rates are incredibly low and prices are super cheap so while I do plan to do a lot of living in this Condo, in 3-4 years I would like to rent it out.

Just to bring you up to speed, these are the numbers I’m working with:
Sale price: $321,000
Down payment: 20% ($64,200)
Mortgage value: $256,800
Interest rate: 3.375%
Term: 30 years
Total interest paid over term: $151,909

That’s quite a lot of money going to interest!  Traditional thinking is to overpay and avoid as much extra interest as possible on your mortgage. That’s definitely a valid approach (and better than spending that money on donuts), however I think it’s actually a pretty high risk with a fairly low return. Let me explain why.

Overpaying Your Mortgage Is Probably A Bad Deal!

If I were to overpay my mortgage I would achieve two things over the course of the year.  I reduce the interest I pay by 3.375% of the amount I overpay over 30 years and I reduce the length by my mortgage accordingly.

First of all I think 3.375% is a pretty low bar for investment gains.  Sure the total interest I pay seems like a lot but over 30 years we can decimate that with boring average stock market returns.

The average stock market return over the past 30 years is 10%. If I invested $5,000 every year over the course of my mortgage I would have roughly $950,000 in stock market gains and that’s with a no effort investment strategy.

After I subtract the interest I would have paid on my mortgage in that time, I’m still left with a net gain of $798,000 ($950k market gains – $152k mortgage interest).  That’s pretty awesome!  If I focused on paying my mortgage back early the maximum gains I could get is the interest I pay on my mortgage, $152,000.  That’s weak and we can do better.

Second and arguably more important, is that my money won’t be locked up in my property.  Say I need cash due to an unforeseen problem, I would have to sell my condo to get access to that cash or take out a loan. We all know that the most optimistic estimations put either of those at longer than 30 days!  That’s a really long time, especially when most equities can cash out in 1-3 days.

What if my condo burnt to the ground?  If most of the money is the bank I can sleep easy but if it’s locked up in the Condo I’m royally screwed until I get the insurance payout.  Even then I’m likely to get around 80% of its actual worth after I fight with my insurance company. As they say, cash is king!

Take The Free Money!

Even with crazy restrictions, banks will let us use up to 40% of our monthly take home on housing payments, even though we probably shouldn’t go that high!  The easiest way to reduce the impact of a second mortgage is to rent your first property. Mortgage companies will let you use 80% of the rent you receive on your first property as additional income to help you receive more overall funding and reduce the percent you spend overall on housing.

Let someone else pay your first mortgage with their rent.  Step on the gas and race faster down the road to financial independence!

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  • Melissa C.

    Should the same concept be applied to not overpaying on a car loan (5 year loan, less than 3% interest rate) and instead invest the extra money that would have gone towards paying off the loan early?

    • At under 3% I think you should definitely focus your extra cash on investing and slowly reduce your car loan over time as your long term (5 year plus) gains in the market will definitely outweigh the interest you pay.

      • Sergio

        Is there a certain percentage above which you wouldn’t recommend investing? I have students loans with an EAR of 6.7%, and I am currently paying way above the minimum. Would I be better served to put that extra income to work in a REIT fund for instance?

        • Sergio, if you have a loan with interest higher than 4% then I’d focus on the loan. You need to remember that loan interest is a sure thing while investment gains are not and need to even out over time.

          Investing is risky and choosing it above paying down a loan certainly amplifies that risk.