How To Lose Debt

A sizable portion of your mortgage payment is to cover the amount of interest that you owe the bank for purchasing your home or condominium.  There are as many types of mortgages, limited only to the creativity of the Mortgage Company and possibly some strategically placed laws.

For the purpose of this discussion, however, there are only two types of loans, fixed interest, and variable interest.  There are hundreds of variations to these two types, like balloon loans where the interest rate is fixed for a particular period of time, say 5 years, and they the entire note needs to be paid off, the balloon, or it is free to be re-negotiated at the then current rate.  Balloon loans and variable interest loans tend to be cheaper, because the risk is less for the bank.

Listen to me very carefully; I am a firm believer in a fixed rate mortgage.  You may pay a slightly higher interest rate than if it was a variable rate loan, but there is no risk that a readjusted interest rate is going to be the cause of you losing your home.  I will show you how to pay off a mortgage quickly, so the difference in overall interest charges will not be that great, and the risk the rate will skyrocket, non-existent.

The mortgage term, which is the length of time you have until the mortgage is paid in full, come in all sizes.  There are the standard, 15 or 30 year fixed, and you can get a high as 40 years, and as low as 5 years, if you could possibly afford the payments. Not highly likely. The longer the term, the higher the interest rate, because the risk to the bank that you will be paying them back with dollars worth less by inflation.

It is known as the time value of money. When you compare what you can buy with $100 today, to what you can buy with the same $100 twenty years from now, the $100 will always buy less tomorrow because of inflation.  Now I want to caveat that to say there is a counter phenomenon called deflation, which has the opposite effect.

But, you are reading this blog to learn how to lose debt.  Therefore, you are not going to be holding onto cash hoping it’s going to be worth more tomorrow.  This is especially true when you factor in the stimulus package of 2009, where the government is printing money like it grows on trees.  The dollar will most certainly will be worth less tomorrow. Then I thought to myself, well paper money really does grow on trees, now doesn’t it?

Let me get back to the mortgage term.  The longer the term, the higher the interest rate. Why then would I advocate you taking a longer term, say 30 years, then a shorter term, say 15 years? Almost seems counter-intuitive? Well there is a method to my madness, I promise you.

When we bought our first house, which was a small Cape Cod in Bergen County NJ, we borrowed $175,000 at 9¾ %. That rate at the time, believe it or not, was a great rate!!  I even worked for the bank that made the mortgage at the time, so I got the “employee” rate.  It was a fixed rate for 30 years.

About 4 years after we bought the house, I was looking at a mortgage advertisement that promised a 6.6%-15 year fixed rate.  So I turned to my wife and said sweets, we have to go for this rate.

You see the difference in monthly payments for a thirty year note at 9 ¾% rate, and a fifteen year note at 6.6% is $31 dollars a month.  Can you believe that? If I refinanced the house, and paid only $31 dollars a month more, the house would be paid off 15 years sooner!!  Incredible we thought.

Sure there was closing costs to refinance the mortgage, but they weren’t high.  There were no points involved at all.

So we went through the paperwork, and refinanced the note with another mortgage company.  My bank actually made it harder for me to qualify as an employee, than if I came off the street, and I had met all payments to date on, or ahead of due date.

Now there are actuarial people who can calculate exactly how long you need to stay in a house, before you recoup the extra closing costs, but frankly, just the thought of paying the mortgage off in 15 years, would have made me move in this direction, even if it cost me more money, which it did, $31 dollars a month plus closing costs.

Now here is the main crux of this mortgage interest section.  Just like credit cards, always, I repeat, always pay more than your “minimum” mortgage payment.  Years ago banks used to charge prepayment fees if you paid more than required.  You see, it costs banks and mortgage companies a lot of money to make a mortgage, legal fees, property liens, etc. so if you pay it off in full 2 weeks later, they lose money.

However, over the years by changes in the laws, and mortgage markets, banks and mortgage companies stopped charging prepayment fees.  So most loan payment forms will have a box to apply extra principal.  If you do not specifically mark it extra principal, they will credit it to your escrow account, or pre-pay interest, which will provide absolutely no value to you whatsoever.  You must clearly specify it as an extra principal payment.

Most mortgage companies, believe it or not, offer special package deals where you pay them extra each month to do a similar activity, where they do the accounting.  Don’t fall for it. You can do it yourself for nothing, simply by making the note on your payment form, and including extra money for principal! The mortgage company or bank is stuck to applying the extra you requested to your loan principal for no additional fees.

So let me give you an example.  A 30 year note at 6.6% for $175,000 would have a monthly payment amount of around $1117 per month.  Add $198 dollars more principal to the same payment, and the loan term drops to 20 years.

Well, the mortgage term does not actually drop, but the extra $198 principal payment will ensure the loan is paid off in 20 years, rather than 30.  Can you believe that, an extra $200 a month will cut 10 years off of a mortgage note??! You are going to lose all debt in no time!

Now here is the most amazing thing on your road to losing debt permanently.  That extra $198 a month not only knocks 10 years off the mortgage note, you will save you $86,740 more in interest than if you paid the regular monthly payments for 30 years.

Did you hear that, that means the extra $198 dollars caused your mortgage to be paid of 10 years early, and you saved $86,740 dollars?!  Isn’t that exciting?  The critical point here is to always pay more than the minimum mortgage payment!!

Now I want to get back to my refinance of my first mortgage.  As I noted before, the interest rate fell from 9.75% to 6.6% when I refinanced.  That allowed the new loan term to be 15 years instead of 30, with a net increase in the mortgage payment of $31.  Awesome, I thought, so that is what we did!

What I learned later in life was that by reducing the term to 15 years, I actually increased my personal risk of default.  Why would that be true, you say? Primarily because the mortgage payments are fixed at a higher amount with a 15 year note. Therefore, if I lost my job, or got sick, or had some other calamity, the risk of not being able to pay the higher mortgage payment does exist.

Let me show you how, using the same $175,000 mortgage example.  The monthly payment on a $175,000-15 years fixed loan at 6.6% is $1534.00 per month, plus taxes, etc.   The same loan for a 30 year term will increase the interest rate slightly, so for example, $175,000 note for 30 years at 6.875%, the mortgage payment would be $1149 per month.  If you were out of work, would you rather have a $1534 mortgage payment you had to make each month, or a $1149 payment?

It is true in this example that I am actually advocating paying a slightly higher interest rate by extending the term.  I recommend this for flexibility purposes.  I still expect you to add the additional $385 dollars principal in this case to your mortgage payment each month; so that the actual amount of time you will be paying mortgage payments is 15 years..

Once again, the term stays fixed at 30 years, but your mortgage will be paid off in 15 years by simply adding the extra $385 principal payment, which in my example; I was going to pay anyway by going to a 15 year term. Does that make sense?

So I was quite excited about refinancing to a 15 year note, when I should have just refinanced for a 30 year term, and paid the $385 more.

Now I fully understand that some people, with $385 a month extra in their hands, will just spend it.  In that case, take the extra risk and go to a 15 year note.  But, if you can be conscientious about making the extra principal payment each month, the longer 30 year term is safer. I want to repeat, always pay more than the monthly payment. Besides reducing expenses, I will provide you with some ideas around generating additional income, which will also help you make additional payments.

We are still working on Reducing Expenses!

This entry was posted on Wednesday, September 16th, 2009 at 1:36 pm and is filed under Mortgage Interest, Reducing Expenses. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.