A meagre 1 in 4 borrowers made extra principal payments on their mortgage last year.
That small percentage could be explained by:
Lack of disposable income
Better uses of cash elsewhere
Perceived hassle of making prepayments
Misunderstanding the compounding benefit of principal payments.
Whatever the case, there are easy ways to make extra payments and erase your mortgage many years sooner.
What follows is a basic strategy to shorten your effective amortization dramatically, and barely make a dent in your bank account.
The idea isn’t fancy. All you need to do is increase your mortgage payments each year to match the rate of inflation.
Over the long-haul, inflation has come in at about 2% on average.
Two percent also happens to be a reasonable expectation of annual wage growth—at least according to long-term averages and income growth forecasts.
If you’re a typical Canadian family earning $68,860* a year, 2% wage growth suggests you’ll make about $1,377 more next year.
So, given the above, let’s consider the median Canadian family with a “typical” mortgage (e.g., a $250,000 loan fixed at 3.99% interest, with a 30-year amortization and $1,187 monthly payments).
If a borrower proceeded down this path and simply paid this mortgage as required, he/she would fork out more than $177,000 in interest over 30 years.
But suppose that person increased his/her monthly payments to match inflation every year.
With a 2% annual payment increase, the payments would look like this:
$1,187 — Initial payment
$1,211 — Monthly payment in year 2
$1,235 — Monthly payment in year 3
$1,260 — Monthly payment in year 4
We’re only talking about a $24 a month payment increase at year one—or just $288 a year. That should be within reach for most people (assuming their annual income rises accordingly).
That seemingly insignificant bump in monthly payments does wonders for one’s amortization. Instead of coughing up $177,458 in interest over the life of a mortgage, this borrower would pay just $135,505 and slash his/her mortgage payoff time by eight years.
If you have a 30-year mortgage and applied a similar strategy, your mortgage could be paid in full in just 22 years.
Even better, if you can afford to increase payments by 3% a year (just $35.62 on top of your regular payments after the first year), you could shrink your amortization down to 19.75 years.
As this example shows, tiny mortgage prepayments can have a dramatic compounding effect.
Moreover, there aren’t many ways to get a better risk-free return on your disposable income. Prepaying a 3.99% mortgage is like earning a ~6% pre-tax return (for those in a 33% marginal tax bracket).
* Sidebar: $68,860 is the latest median family income data from StatsCan. It’s actually data from 2008 but it suffices for illustration purposes.
Rob McLister, CMT
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