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

  1. “Perceived hassle of making prepayments” — this was definitely the case for us way back when we had our first mortgage. We doubled our monthly payments for more than 2 years, and every time we made the extra payment the person at the bank met us with “you want to do what???” Either we were the only people who ever took advantage of the extra payment privilege or the bank staff were trained to make us as uncomfortable as possible.

  2. Great post Rob and very sound advice for most people to follow.
    I recall in the early 90’s when I was a former broker Firstline offered a product called “Accelerator 150” where the lender automatically increased the payment by +5% on each annual anniversary. It had a fixed rate for 12.5 yrs at rates comparable to the bank’s 5 yr posted rates at the time. By compounding the 5% annual increases in payments the 25 year amortization (the maximum at the time) was paid in full in exactly 12.5 years (150 months- hence the name). Borrowers could also prepay up to 15% annually in lump sums of $100 minimum at any time to pay the mortgage off even sooner.
    After CIBC bought Firstline in the mid 1990’s this product was shelved -too bad as it was a great product that provided rate stability as well as a true game plan designed to be mortgage free.

  3. Thanks Eric,
    Interesting. Hadn’t heard of that product.
    I suppose consumers could replicate it somewhat with two consecutive 5yr terms (or one 10-year term at ~4.89% today) and manual payment increases each year.
    As a side note, we did a study a while back that found consecutive 5yr terms beat a single 10yr term about 9 in 10 times historically. I have a feeling that would also apply to a 12.5 year term at posted 5yr rates.
    Thanks again for the post…Cheers, Rob

  4. Hi Michael,
    That’s funny.
    Staff turnover at some lenders certainly makes for hit-and-miss customer service sometimes.
    It’s nice when a lender lets you make payment increases online. All lenders should have that functionality and it absolutely shocks me that, in 2011, some still don’t!

  5. Great post Rob, and a terrific illustration of the power of compound interest. The only thing I would quibble with (and just barely) is that cost-of-living type increases are just that: necessary to maintain equivalent purchasing power as inflation does its thing. So if you take that 2% and increase your payments each year, you don’t have any slack to pay for the increased price of food, fuel, etc.
    It’s so minor, however, that many homeowners should be able to make room for it in the budget.
    In some professions (and especially those in the public-sector), compensation is partially based on years of experience, so a teacher or police officer may receive a 3-5% bump in addition to a cost of living increase. So as not to stoke anti public-sector rage, I feel compelled to point out they don’t get these experience increases in perpetuity – you generally top out at your pay grade after a few years…

  6. Thanks Al,
    It’s funny you bring that up and I’m glad you did. It validates an internal debate I had when writing this piece. As a point of fact, we did consider disclaiming the point that a 2% CPI increase would cancel out a 2% nominal wage gain. The main reason I didn’t was to simplify the example (i.e. not to get into a real wage discussion and detract from the main point).
    The other reason was this. A 2% rise in mortgage payments ($288 a year in the example) comprises a minority (21%) of the $1,377 wage increase used in the example. As it turns out, nominal wage growth has been running above CPI for much of the last decade (chart via Worthwhile Canadian Initiative). That means there’s some money left over after inflation for the average mortgagor–ideally enough for $288 worth of extra principal payments. If real wage growth continues (fingers crossed), it should trivialize the nominal/real wage distinction for these purposes.
    Suffice it to say, whatever your true income gain, devoting a small portion of it to payment increases, when possible, has a fantastic compounding benefit!

  7. Great article!
    I think it is important to look at “net worth” not just debt reduction. If I have an investment giving me higher net returns than what I would save on my very low mortgage interest rate, I would rather a higher net worth when I retire than simply to be debt free.
    Or try both: max out your RSP, then take your tax return from doing so and put that on your mortgage.

  8. Thanks Michelle,
    You’re absolutely right. To be even more specific, it’s important to look at net worth, time horizon and risk-adjusted returns. An 8% return may seem great compared to a 6% tax-equivalent return from mortgage prepayments. But it’s not so great if the 8% return comes with high volatility and the mortgagor needs the money in less than 5-10 years for example.
    As always, there’s lots to consider when making investment decisions.

  9. Thanks Rob – real wages have certainly grown over the past decade, so there should be some additional room for the average worker. One of the things I like about this approach is that it is fully customizable – if your wages grow 5%, you can raise 5% (or 3%), or whatever.
    Your key point is well taken – it’s a good idea to make small payment increases that you probably won’t miss but which will add up to a lot of cash over time. Given that my next raise comes at the end of June, I’ll have to make a call to my lender!

  10. Excellent article. We’re hoping to do this and more Rob. Your post reinforces what many mortgagors should find out if they don’t already know – every penny counts when it comes to debt reduction :)

  11. Thanks Mark, The nice thing, as Al R says, is that one can adjust the payment increase to his/her percentage income gain…so that the money is not missed. It’s a very basic and non-glamorous strategy, but effective.

  12. Informative post Rob! It’s good to know what the effective ways of shortening the amortization are. For me it’s very detailed because I can able to fit and adjust my income in my loan. And it’s a wise move, so at least lessening the duration of amortization also lessening the interest, because every cents counts.

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