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Advice-making extra mortgage payment

Question: I’m thinking about making one extra mortgage payment per year. If I split it by 12 months, it would only be $54.00 extra per month. We’re probably only going to be in our house for 5 more years (been there 2 already). My question is if it’s worth it to make that extra payment or should I just stick it in savings. The mortgage interest rate is 7.5%, obviously higher than the interest my savings account earns. We got a mailing from the mortgage co trying to get us to switch to paying half the monthly mortgage every two weeks (so you make one extra payment per year). According to them, it would cut $28,000 of interest off the life of the loan. Of course, they want to charge us $370 to save money, I figured I’d just make the extra payment myself.

Answer: Well, assuming that you are able to itemize your tax deductions each year, that you in a 28% federal marginal rate and that you pay a 5% state tax as well (that’s what I pay), your ‘real’ interest rate is only 7.5% times (1 – .28 -.05) = 5%. It is pretty easy to make that much from a five-year CD or from most uninsured corporate bond funds (now paying about 7% with a five-year average maturity). Substitute your own state and federal marginal rates into the equation and find out what your real interest rate is–it is, of course, 7.5% if you don’t itemize. Now if you take that $648 annual payment and you save it all in a CD or whatever, you should find that you don’t really save much by making the early payment. In fact, you will probably loose a little bit. The quick answer then: Don’t bother it doesn’t matter much one way or the other.

Here’s an intangible to consider: Do you have enough cash reserves for an emergency? If you don’t have enough cash to cover loosing your job, uncovered medical costs or whatever, you may have to get a loan on the equity in your house. If, instead, you have that money sitting, for example, in a CD or a bond fund, you will find it much easier and cheaper to get your hands on it than taking out a loan with your house as collateral. The quick answer: Always keep enough savings or cash reserves to make sure you don’t have to get an expensive home equity loan. I hate it when I see loan companies doing this. You are, of couse, just better off making an increased payment to your principal than doing this. The quick answer: Don’t do it. Also consider: the next time you buy a house five years from now, consider getting a 15-year loan instead of the more typical 30-year loan and buying no more house than you really need. This is really the frugal approach. The payments will be higher but, overall, interest you pay will be much, much less and the annual interest rate will be about 1/2% as well. Moreover, by the time the loan is paid off you may be ready to retire you may be very happy to have the loan paid off and the extra cash available for living expenses. Keep in mind the cash flow problem though, if you do not have enough in savings or other easily accessible funds, you may have to take out a loan to meet emergency needs–another reason to buy no more house than you need. The quick answer then: Buy no more house than you need and keep the shortest loan period you can afford.

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