Hi bbaird,

On months when I have money left over after all bills and mortgage payment, should I pay off additional principal on the mortgage or put the money in the bank to accrue interest and pay a large lump of additional principal somewhere down the line (once per year, every 2 years, etc.)?

The answer to your question depends on some variables;

A) Do you have a seperate safe cash savings (or checking, collection of CDs, or similar) account with at least the equivalent of 12 month's worth of your total monthjly living expenses (including housing, taxes, insurance, food, travel, emergencies, etc.)? If not, keep sending your extra dollars into that until you do have that completed.

A2) Do you have *ANY* outstanding balances on consumer debts (credit cards, car loans, non-subsidized student loans)? If so, after getting at least 3-6 months of #A done, knock down ALL these to zero balance & keep them there monthly.

B) If you have fulfilled #A completely, have you had an insurance checkup, and made sure that all your family and household risks (including loss of income) are sufficiently covered, with your annual premiums paid-up? If not, get that done before moving to the next cascading bucket.

C) If you have #A and #B done, have you maxed out your ROTH IRA? (Do you HAVE a ROTH IRA? If not, go get it now.) If you haven't filled up your ROTH, do that next with the additional dollars,

NONE of the above is provocative, or even questionnable.
The next step of advice is your discretionary option;

D) If you have completely funded A, B, and C... then I recommend dollar-cost-average investing to build up a side investment account (appropriately balanced to fit your income/career stage in life) UNTIL you have accumulated AT LEAST enough of an account that you could cash it out and then in one check pay off your entire mortgage in full.

After our last 2 weeks of markets implosion, NOW is possibly among the best time IN ALL OF OUR LIFETIMES to begin dollar-cost-average buying... as the markets are now presenting averaged-out opportunity, going forward, unlike anything that has been available in decades!

LASTLY... VERY LASTLY....

When you are finally financially independent, with your side investment funds worth far more than any and all of your debt (including your mortgage,) and you no longer have any desire for investment growth... THEN (and only then) is it prudent to finally put to rest your real estate leverage (your mortgage.)

If that's helpful, let me know.

Cheers,
Dave Donhoff
Leverage Planner

Hi, Dave.

I appreciate all your input, but, I'm interested ONLY in knowing whether I'll save more money by accruing 1-2% interest on the extra money, or, paying it toward my principal each month.

I've been trying to crunch the numbers, but, as I've said, my head's exploding. Intuitively, it makes more sense to me to get my bank account interest and then pay off the principal when I reach some sort of tipping point (where it's not cost-effective any more). Isn't there a point at which it doesn't pay any more to hold onto the money? There has to be a point of diminishing returns at which it's too late to pay off the mortgage and save a significant amount of money.

Thanks in advance.

Go to http://www.fool.com/foolu/askfoolu/2001/askfoolu010307.htm

for the answer to your question and a calculator to figure out your own situation.

Speaking of heads exploding, a personal pet peeve: seperate

There's "a rat" in separate.

If you are going to make additional principal payments make them when you have the money.

It makes no sense to save up money earning a lower rate than the mortgage rate costs you.

You are paying every day on the mortgage balance.

Unless you have a decent amount of money saved for emergencies pre-paying is often not without risk.

You would need a second mortgage to retrieve the money you have pre-payed if you need it for anything.

separate

forever an editor,
mando

sorry, mary, didn't see your post.

Hi bbaird,

I appreciate all your input, but, I'm interested ONLY in knowing whether I'll save more money by accruing 1-2% interest on the extra money, or, paying it toward my principal each month.

OK... ignoring tax treatments... you still have an uneven playing field between sending your dollars to the retirement of interest-bearing debt (a one-time (but enduring) savings benefit event each time you pay,) and sending your dollars to an interest-earning savings account which accumulates on a compounding basis.

Compounding returns will outperform flat savings, rate-point to rate-point, eventually over time.

In other words, 4% returns grown with compounding will outperform 5% flat interest costs (or the savings derived by eliminating that flat 5% cost) at some point in time.

Mathematically, EVENTUALLY, your 1-2.25% compounding interest credit growth will outperform your 5.875% flat mortgage interest.... HOWEVER (without actually running the numbers) I would bet that it would take so incredibly long as to be an ineffective trade-off.

If that is really your ONLY variable consideration... you'll outperform (within a timeframe that matters) by paying into the mortgage and surrendering that amount of principal leverage.

I've been trying to crunch the numbers, but, as I've said, my head's exploding.

I totally understand.... I've splattered my brains many times while learning the mathematics of how this all plays together myself ;~)

Intuitively, it makes more sense to me to get my bank account interest and then pay off the principal when I reach some sort of tipping point (where it's not cost-effective any more). Isn't there a point at which it doesn't pay any more to hold onto the money? There has to be a point of diminishing returns at which it's too late to pay off the mortgage and save a significant amount of money.

Your intuition is correct in telling you that there's some "cross-over point" over time... but its actually the reverse effect of your intuition. The longer you can delay surrendering the mortgage leverage, AND have your discretionary funds growing on a compounding basis, the less and less advantage you get by stopping doing so.

Cheers,
Dave Donhoff
Leverage Planner

dave and scdeb,

Thank you, both. I know what I'm asking is difficult to answer without real numbers. I appreciate your answers.

This may be common knowledge, but I just found this out and it has been bugging me ever since. I'm paying $500/month extra principal payments on my mortgage. If I paid the $6000/year once each year, it would have saved me 5 months at the end of my mortgage. If I had known this earlier, I would have done it from the beginning.

I'm tempted to start now (5 years later) but there's a stupid reason I'm not doing it....

I now know when my last payment will be. If I change the payment structure now, I'd be lost.

So, paying it asap is always better, it seems. I'm wondering if paying on the 20th would be better than paying on the 30th? Compounding is a great thing.

"I've been trying to crunch the numbers, but, as I've said, my head's exploding."

"I totally understand.... I've splattered my brains many times while learning the mathematics of how this all plays together myself ;~)"

Excel is your friend.
It is not very hard to set up a cash flow scenario and then extend it out as long as you want.

There is no simple math to even determine what the interest/principal allocation is for an arbitrary payment number on a declining balance mortgage.

Amortization tables are actually computed line by line starting from the original conditions )Principal, rate, payment).

There are equations that easily tell what payment is required to retire a stated principal over n payments at a fixed rate.

Set up the cash flow in Excel and see were it goes.

"This may be common knowledge, but I just found this out and it has been bugging me ever since. I'm paying $500/month extra principal payments on my mortgage. If I paid the $6000/year once each year, it would have saved me 5 months at the end of my mortgage."

It's not common knowledge to me.

See--this is why my head's exploding :)

"This may be common knowledge, but I just found this out and it has been bugging me ever since. I'm paying $500/month extra principal payments on my mortgage. If I paid the $6000/year once each year, it would have saved me 5 months at the end of my mortgage."

If all you are concerned with is paying off the mortgage faster, paying $500 a month will be faster than saving up till the end of the year and making a single payment of $6000.

Interest is computed EVERY MONTH on the balance of the mortgage.
Each payment is than applied to the interest, and the remainder goes to the principal.
If you pay $500 extra, the next months balance will be $500 less, resulting in more money going to principal the next month.

One simple way to envision this is to look at an amortization schedule.

If you made an extra principal payment of the NEXT months principal, you would 'skip' ahead one month on the amortization table, and shorten the loan by 1 month.

If you make a $500 payment to principal you can add up the monthly principal portions on the amortization table until you get to $500 (or as close as you can without going over).
This will be the number of months the mortgage is shortened by.

It is easy in the first years to shorten the mortgage, but gets harder in the latter years since the portion f the payment allocated to principal is rising as the balance decreases.

10 people will give you ten different answers to this, however using the mortgage calulator on b**krate $167/mo
shortens my 30 yr loan to 20. With that done the rest funds my Roth and SEP Ira's, the former is going to fund my next deal through a self-directed Ira eliminating capital gains from flips.

"...10 people will give you ten different answers to this..."

And at least nine of them are wrong, and possibly all ten.

"paying $500 a month will be faster than saving up till the end of the year and making a single payment of $6000"

Oh yes, I understand. I was thinking of paying it in the beginning of the year with cash on hand instead of having my cash sitting there in a checking account while taking $500 out of it each month to pay the extra principal.

In my case, it is in a checking account and I just wait for each month to pay it. Might as well "sign it over" to them in January, every January instead of the $500 each month.

Again, that will save me 5 months off the back end.

Actually, I also figured I could pay less than $6000 if I chose to pay it once/year and my payoff date would be the same as if I were paying $500/month. I forget the number, maybe $5500? or so every January, and the payoff would still be the same as $6000 over the course of a year.

To the OP, I'll second that the bankrate website should be visited and punch in your numbers. It will give you a lot of info you may use. good luck

"Actually, I also figured I could pay less than $6000 if I chose to pay it once/year and my payoff date would be the same as if I were paying $500/month. I forget the number, maybe $5500? or so every January, and the payoff would still be the same as $6000 over the course of a year."

If you are comparing paying $6000 on January forst with paying $500 a month over a year the lump sum is better.

If you are comparing $500 a month or a lump sum in December (12 months later) the $500a month is a better deal.

The faster you can reduce the balance you are charged interest on the shorter the mortgage duration and the interest expenses.

Just remember you are unleveraging an asset, and you can have problems getting a new loan if you need the money back.

If you are able to pay out 6000.00 in January in one lump sum, then you are doing it wrong. You should have been sending that money in the previous year as it became available and reducing the principle. Overall that would be your best money saving scheme.