This blog contains some simple tips and advice from two regular guys. We're not accountants, financial advisors, or brokers, so follow, ignore, or discuss our ideas as you see fit.

Friday, October 5, 2007

The mortgage pre-payment conundrum

Posted by Matt
If you've been reading any of the recent posts on this blog, you'll know that I just bought a house and will be moving soon. For the last month or so, I've been trying to figure out what type of repayment plan (or prepayment plan) for the mortgage makes the most sense. I've heard and read about money-merge accounts, bi-weekly payment plans, extra principal payments, etc., etc.

I've finally made my decision, but let me take you through the options.

  1. Money merge accounts - these are popular in Australia, but I'm having a hard time coming up with a simple way to explain how they work. I usually take that as a sign that I should steer clear. If you want to read more on the topic, check out wikipedia or just google "money merge"; there are suddenly tons of articles about them.

  2. Bi-weekly payments - this is a comparatively straight-forward option. Bi-weekly mortgage payments mean that you make the equivalent of one extra monthly mortgage payment per year, and the more frequent payments also forestall interest accumulation. Using a simple calculator, I determined that a bi-weekly payment schedule would cut 5 years off our repayment and save $73867.04. Sounds good, right? One warning: if you decide to do this, DO NOT sign up with one of the many fly-by night companies that sends out junk mail offering to set it up for you, as they will tack on hefty and unnecessary fees. It is a free option at our bank and probably most others.

  3. Extra principal payments - probably the simplest and most flexible method. Wells Fargo bank allows us to transfer extra money to the mortgage from one of our other accounts. At some banks, extra payments are applied toward future interest payments, so make sure you follow your bank's requirements for applying payments directly to the principal balance. Wells Fargo does this for us automatically and even provides an option to schedule automatic extra payments.

After giving it the options a lot of thought and doing some more research, I decided that I don't want to prepay at all due to an important concept called "opportunity costs" (which I actually remembered from a college economics course, so I guess I got my money's worth that day!) Say I have $100 burning a hole in my pocket and decide to throw it toward the mortgage. In doing so, I give up the opportunity to spend that money elsewhere. An economist would advise that each spending decision you make first requires an evaluation of whether there is a more rewarding opportunity available.

So, here are some of the options I have to weigh and determine which has the greatest reward:

  1. extra principal payments to my mortgage
  2. additional contributions to my emergency savings account
  3. additional contributions to my retirement accounts
  4. Contributions to my son's 529 education savings account

I tried to come up with an exact algorithm that would determine which of these would put me the furthest ahead strictly in terms of my future net worth, but the number of variables make it very tricky. There's a great paper on the topic with some scary equations, but I felt like it really required one too many looks into the crystal ball (what will my investment returns be? what tax bracket will I be in later in life?). My takeaway is that options 3 and 4 above are probably the highest priorities for me right now, with one caveat: whichever option I choose, I must set up a system to regularly and automatically fund it. The main strength of the bi-weekly mortgage payment plan, for example, is that it is automatic, so it could potentially be a better choice for some people if they feel that they lack the discipline to regularly make manual contributions to their IRA.

So, my wife and I will revise our budget (after we complete our move) and figure out where the extra money should go and how we can make sure it gets there!

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