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
- 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).
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