Three Reasons You May Not Want to Make Extra Mortgage Principal Payments


paying on your mortgagePaying off a mortgage is one of the most basic milestones of financial freedom. Life without a mortgage payment–does it get any better than that?

But a mortgage is a huge debt, so most financial advisors recommend paying it off gradually with additional monthly principal payments. That can chop years off the length of a mortgage loan term and save thousands in interest as it does.

Good deal? Not necessarily. Yes, it’s a good way to retire your mortgage early, but it’s not without consequencesâ”three of them that I can come up with.  If you are retiring in Australia and want some info on mortgages, check out the one of many mortgage brokers sydney.

Loss of liquidity

When you make extra principal payments, you effectively tie money up in your home. Once money is paid into a mortgage, the only way to get it outâ”should the need ariseâ”is either by selling the home, or by taking a new loan on it. You probably don’t want to sell your house, and taking a new loan defeats the purpose, if paying it off is what you were trying to accomplish.

Houses aren’t particularly liquid, especially these days. Not only is it hard to sell a house, but there’s virtually no way that you can cut off a piece of it and sell it to raise cash the way you could with a mutual fund. Simply put, a house isn’t a liquid asset, and any money you pay into it will be effectively lost until the day the house is sold or a new mortgage is taken out.

Additional principal payments will actually reduce your liquidity, should you need money for emergencies, for investment, or for payoff of non-housing debt.

You won’t lower your monthly payment

If your mortgage is fixed rate, your payment will also remain fixed until the loan is paid in full. There will be no benefit in the form of a lower house payment as a result of additional principal payments. If you’re payment is $1,000 a month with a $100,000 mortgage balance, it will still be $1,000 when you pay the loan down to $20,000.

Additional principal payments will do nothing to lower your monthly expenses, and will even reduce your cash flow by the amount of the additional principal contribution. By making additional principal payments, you may reduce your loan term from 30 years to, say, 15 years, but you will still have the same monthly mortgage payment (plus extra principal) for each and every one of those 15 years.

The mortgage tax deduction benefit will go away quicker

This is a factor seldom included in the additional principal discussion: as you pay down your mortgage balance, the amount of interest you pay on the loan will decline faster and, as a result, you’ll have less mortgage interest to deduct on your income taxes.

For a lot of homeowners, the tax deductibility of mortgage interest is a major reason why they can afford their payment, and why owning a home is more affordable than renting, which has no income tax benefits. The $1,500 a month payment that was reduced to $1,000 by the mortgage interest deduction, will move closer to the actual $1,500 as each year passes. The bigger your house payment is, the more painful this will be.

Instead of making additional mortgage payments, try thisâ¦

There’s a way to payoff your mortgage early without having issues with liquidity, monthly house payment or loss of tax deductions. Instead of making additional monthly principal payments on your mortgage, put the extra payments into a mortgage sinking fund.

Before you get to thinking that a sinking fund is something exotic, understand that it’s just an accounting term that describes an account that’s set up to retire a debt. The idea is that you make periodic payments into the sinking fund that will enable the eventual payoff of the debt, without making payments to the debt itself. The sinking fund itself can be a bank account, money market fund or certificates of deposit that hold the money in a safe place until it’s sufficient to payoff the debt.

There are several advantages to using the sinking fund method to payoff your mortgage rather than the additional principal method:

  • Since the money is in an account under your control, you keep liquidity until the loan is paid in fullâ”you’ll have money for emergencies and investing opportunities in the meantime
  • You can earn interest on money you’re salting away to payoff your mortgage
  • The sinking fund enables you to payoff the mortgage and eliminate the payment on the same day
  • Your mortgage income tax benefit will remain fully intact until the time of payoff
  • Should you decide that you don’t want to payoff the mortgage, you still have the money that would have paid it offâ”no need to sell the house or take a new loan
  • You’ll be in a forced savings routine, and once the mortgage is paid off, you can continue saving, but with the mortgage payment gone, you’ll have even more to save

There are so many reasons to payoff your mortgage using a sinking fund that it’s surprising it doesn’t get more attention. Maybe it’s because the idea of saving up a six figure savings balance is beyond comprehension to many people. But think of it this way: if you can payoff a six figure mortgage, you can just as easily build up a six figure sinking fund to make it happen.

Do you think you can do it?

photo by akzo

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Written by Kevin

With backgrounds in both accounting and the mortgage industry, Kevin Mercadante is professional personal finance blogger, and the owner of OutOfYourRut.com, a website about careers, business ideas, money and more. A committed Christian, he lives in Atlanta with his wife and two teenage kids.

Kevin

With backgrounds in both accounting and the mortgage industry, Kevin Mercadante is professional personal finance blogger, and the owner of OutOfYourRut.com, a website about careers, business ideas, money and more. A committed Christian, he lives in Atlanta with his wife and two teenage kids.

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