The first and most important thing for people to realize when the topic of paying down their mortgage is concerned is that you should not ever view your mortgage debt in isolation.
You wouldn’t think that this would be much of an issue considering that debt is debt, and people should always be thinking about all of their debt, not just one component of it. Of course, if the only debt that people have is their mortgage, that’s going to get all of their attention, but often times people do have a variety of debts and end up focusing too much on paying their mortgage down as quickly as they can without proper regard to the big picture.
The only sensible way to approach debt is to look to minimize interest costs, and given that mortgages are the lowest interest product people have, paying more than you have to on your mortgage should only even be considered when one is debt free.
Even then, it is wise to prepare for one’s future needs by ensuring that their future needs can be managed sensibly, which does not mean paying extra on the mortgage and then turning around and borrowing at a higher rate.
While being mortgage free one day is a nice goal to have, being debt free is even more important, and it does people no good to have paid off a lower interest product at the expense of higher interest debt. This never makes sense to do.
It may even seem crazy that anyone would ever do this to those who have not had this experience, but it does happen a fair bit, and often times these people are back at the bank looking to refinance their mortgage to add on this other debt, or to look to borrow some more as the need arises.
How People Get in Trouble With This
A great many people mess this up and the biggest mistake they make is setting their mortgage payments higher than they need to be. While there are some people who are in a position financially to make larger payments than required on their mortgage, this is only really the case if someone can say with a lot of confidence that they will not need to borrow over the life of the mortgage.
Needless to say, that’s not a very high percentage of people, a very small minority actually. Among the overwhelming majority of people who either have other debts or may be expected to incur them, quite a few of these people do choose to pay too much on their mortgage and this ends up costing them money in the long run, often a lot of money.
The reason this happens is that people look at the longer amortizations that mortgages come with and feel better about reducing this period, which is only natural really. However, we need to take that preference and incorporate it in the bigger picture of long term debt management and ensure that we put ourselves in the best position we can to pay the least amount of interest.
There are people who have even lost their homes over this, where they set the payment higher than they need to, something happens like they lose their jobs, and eventually they end up defaulting where they may not have if the payments were made more modest.
These mistakes occur both in selecting the original amortization and payments for the mortgage, as well as after refinancing, and it’s actually the refinancing phase that more commonly gets messed up..
After having a mortgage for a number of years, people tend to be reluctant to do the right thing and maximize the amortization, which in most cases is the right thing to do. If you took out a 30 year mortgage for instance and 10 years later you’re setting it back to 30 years again, this can seem to many to be rather disheartening.
If you’re back adding debts to the mortgage and re-doing it, in just about every case this means that you do have additional borrowing needs beyond the mortgage. Even if you handled the other debts pretty well, it’s still usually preferable to get this debt refinanced at mortgage rates, but often times people don’t manage their debt that well to get to this point.
So, what often happens is that people choose a shorter amortization than the maximum when they refinance, and then the need to borrow comes up again. This does make sense to do sometimes but most of the time it does not. You can’t decrease the amortization of a mortgage without refinancing it again, so they are stuck with more money on the mortgage when it could have been used to pay down this other debt.
People may also choose what are called accelerated payments, which essentially just serves to reduce the amortization of the mortgage by the amount of the extra payments, and this sounds pretty good at the time to a lot of people. Once again, who wouldn’t want to pay down their mortgage faster?
The tendency is not to think this through though, the clients don’t think it through properly, and the mortgage lender’s rep doesn’t tend to do too much thinking as well, so people agree to these terms.
Using Higher Payments to Try to Compensate for a Lack of Discipline
You often hear the argument that since most people don’t manage to pay their mortgage down faster if it is left up to them, the only good way to do this is to force them to do it, if they wish to be forced that is.
So, they may end up agreeing to this, and for whatever reason lenders don’t really discourage this practice, even though it does increase their risk. They don’t really train their people very well as far as how extra payments factors into risk management for the lender, but it’s not hard to figure how higher payments lead to more financial difficulty for the client often times, as well as increasing the default rate.
The higher the payments are for a mortgage, the more likely that the borrower will default, and this is just common sense.
Forcing people to pay more in order to not lose their house doesn’t lead to a lot more defaults, but what it does lead to is people paying more interest, and that’s the biggest thing with these higher payments.
People who lack the discipline to make extra payments when they can on a voluntary basis usually lack financial discipline in general. The worry here is that they will spend the money rather than put it on the mortgage and this does happen. This leads to their usually still spending the money, only now they are doing things like racking up their credit cards too much.
The reason why this generally is not a good strategy is because it ends up prioritizing paying down the mortgage over managing other debt, and this is never a good choice. The mortgage needs to be the least prioritized form of debt, in all cases, and this includes and especially includes future borrowing needs.
The Right Way to Pay Down Your Mortgage
Once again, the only time people should ever contemplate mandating larger payments on their mortgage than the minimum is when they are sure that they won’t need to borrow money again, not just over the next couple of years but over the life of the mortgage, which may be up to 30 years.
This list does not include a lot of people as you may imagine, and even people who are very wealthy borrow money at rates higher than mortgage rates quite often. One would have to be extremely frugal and expect to be able to maintain that for many years, as well as also having excellent income stability, perhaps a guaranteed pension.
So, someone could be on a fixed guaranteed income and swear off borrowing for the life of the mortgage, or at least be reasonably certain that they are not going to need to borrow for the rest of the mortgage. This can happen, for instance, if one has excellent job stability and is going to retire soon, and the prepayment options just aren’t enough to take care of their needs.
The thing is though, the prepayment options are going to be more than enough to accommodate just about everyone’s needs as far as paying their mortgage down goes. You can pretty much pay it down as fast as you want with these options, and they should be taken advantage of when it is wise to do so.
It does require some discipline to put extra on your mortgage when it is good to do so and not just blow the money, but if you are blowing your extra money, that’s a problem in itself of course. If this is the case, it’s still better to make the minimum payments on your mortgage and blow your extra money rather than to commit yourself to bigger payments and expose yourself to more risk.
Even with voluntary extra payments, it’s still important not to be too aggressive with this, and mess yourself up by having this lead to more interest paid. It’s a good idea actually to take the extra money that you have and only put a portion of it on your mortgage, with the rest going into a savings account, to be used as a contingency fund.
The amount that needs to be held back depends on what you foresee your potential future spending to be, and if there’s a good chance you’d have to borrow for something, it’s better to save up for it and use your own money.
You don’t want to overly weigh things towards the savings though as there is an opportunity cost for this, it could be on the mortgage rather than in your savings and this is going to cost you money. You want to use this to avoid the bigger stuff like higher interest debt and especially credit card debt.
Overall, while it’s certainly good to pay down any debt quickly, you need to be careful with installment debt, because you can’t get it back once you’ve paid on it. Mortgages require special care as people commit to larger payments long term with it, and mistakes made can be quite expensive to fix.
Editor, MarketReview.com
John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.
