Most people seem to be obsessed with paying off their mortgage early, whether it’s good for them or not. Clearly it’s a psychological victory to tackle a giant debt and free yourself from the grips of your evil mortgage lender.
I’ve already discussed the pros and cons, but let’s look at another reason why it could make sense to pay your mortgage more quickly.
We know you can save a ton of money on interest by paying the mortgage faster, especially if you have a 30-year fixed mortgage, which by name alone tells us it’ll take a while to pay in full.
Sure, you can wait three decades to burn your mortgage, but you can make extra payments early on and extinguish it a lot faster.
Only Keeping the Mortgage a Few Years?
You can also benefit even if you don’t actually keep the mortgage for the full term, or anywhere close to it.
Let’s imagine a scenario where you buy a home and only keep it for three years before selling. This isn’t an uncommon scenario at all. It’s very typical for homeowners to buy a starter home, live in it for five years or less, and then move on to something bigger and better.
This tends to work out fine in a normal housing market. You put down 20%, pay the mortgage for several years, and then sell at a profit and use the proceeds for your new home’s down payment.
But the game has changed. Today, borrowers are coming to the table with a lot less because they’re struggling to gather the necessary down payment of old. This explains the popularity of the FHA’s 3.5% down program, and the newer 3% down program from Fannie and Freddie.
The problem with these loan programs is that you start with very little equity. Additionally, your monthly payment is higher because you’ve also got a higher loan amount as a result. After all, less money down equates to a larger loan balance.
So you have higher payments to make, especially if mortgage insurance is a factor and you have a higher interest rate (thanks to the high LTV), and very little equity. Not a great start to your foray into real estate.
You Might Not Have Enough Money to Move
Imagine someone puts down 3% on a $200,000 home purchase. That leaves them with a loan amount of $194,000.
If they go with a 30-year fixed (which is quite likely) and obtain a mortgage rate of 4.5%, they’ll only pay the balance down to just over $184,000 after three years.
Now assume they want to sell the home and buy something bigger because they had a baby. Well, factor in real estate agent commissions of 6% and other closing costs like title, escrow, transfer taxes, and that could swallow up a good chunk of the sales proceeds. Let’s say 8% of the sales price total.
This would be just fine if home prices rose significantly over that time, but if they were largely flat, and the subsequent sales price was just $205,000, the proceeds with 8% sales costs would be just $188,600.
That’s less than $5,000 in the homeowner’s pocket when all is said and done, not enough for a new down payment on a more expensive home. In fact, it’s less than $4,500, and that could all go toward moving expenses alone.
For the record, companies like Zillow consider borrower equity of less than 20% as “effective negative equity” because it’s generally not enough to sell and buy another home.
Purchase price: $200,000
Sales price: $205,000
Closing costs: 8% ($16,400)
Proceeds from sale: $188,600
Ending mortgage balance after 3 years: $184,200
If you were to pay an extra $100 a month on the same mortgage for those three years, the proceeds would be over $8,000. If you paid $200 extra per month, you’d be looking at over $12,000 in proceeds.
Alternatively, you could go with a 15-year fixed mortgage and pay down the balance to around $163,000 after just three years (assuming a lower mortgage rate of 3.75%). In that case you’d wind up with proceeds of around $25,000.
So even if you aren’t planning to stick around and burn your mortgage, you can still benefit from paying it down at a faster rate over the short term.
The same is true if you don’t sell but eventually refinance. With more equity, you’ll have more options to refinance if need be.