Written by 7:10 PM Mortgage Strategies • 13 Comments Views: 1

Strategy: Inflating Your Mortgage Payments

Money in the bankA 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
  • Indifference; and/or,
  • 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).

Mortgage-prepaymentsIf 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
  • etc…

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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Last modified: April 28, 2014

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