Cutting Years, and Thousands, Off Mortgage

Blame part of it on growing up in the Great Depression and the rest of it on having been raised by a grasshopper and an ant--a father who saved nothing and spent all and, fighting him every foot of the way, a mother who would walk the full length of Brownsburg, Ind., to pay her electric bill in cash to save the check charge and the 3-cent postage.

From this came a man who vacillated wildly between impulse buying (you never know when you’ll need a solar-powered can opener) and a compulsion to save string.

But it was home ownership and my introduction to the miracle of the amortized mortgage that began tipping me into the camp of dear old, penurious Mother. While never a genius in math, to my simple mind there was something extremely curious about my first home mortgage--a 5%, 30-year Veterans Administration loan for $14,000.

Of the $79.69 monthly payment for principal and interest, $21.36 was going toward interest. And even in the days before the hand-held calculator that didn’t figure out to any 5% for interest, but to 27% of my monthly payment. How long had this been going on?

As time moved on and the price of succeeding houses leap-frogged and 5% interest became quaint, the lopsided structure of the amortized mortgage became more and more of an irritant to my Scottish soul.

The simple economics and the tremendous savings involved in accelerating the principal-only payments on a home mortgage remain strangely unappreciated.

Tangible Value

On a $120,000 mortgage at 10%, adding an extra $25 a month to the regular payment of $1,054.10 for principal and interest knocks the mortgage down from 30 to 26 years and trims $37,402 off the interest.

Most financial advisers look at the tax deductibility of the mortgage interest on a home, the anticipated appreciation and the impact of future inflation, and stick to the same old formula: pay as little down on a home as possible and invest the difference.

But, as Mother knew instinctively, the real in real estate is a tangible that in good times and bad maintains a value that paper investments can lose overnight.

In the previous example--a $150,000 home on which the buyer has made the conventional 20% down payment ($30,000) and is facing a $120,000 mortgage at 10% over 30 years--that $1,054.10-a-month translates as a pay back of $379,476.

That’s the original $120,000 borrowed, plus $259,476 in interest, or a return to the lender of 216% on his money. Not bad for a 10% loan. Consider, too, that of the $1,054.10 monthly payment (in the first month) on this $120,000 loan, $54.10 is going to the reduction of principal.

More for Principal

But, of course, with an amortized mortgage every month a little bit more goes to principal and a little bit less goes to interest.

By the end of the 10th year, $145.24 of that monthly $1,054.10 is going to the reduction of principal, about 13%. It takes 23 years of that 30-year mortgage before the monthly payment splits 50-50 between principal and interest.

The final seven years is catch-up time, when the lion’s share of each month’s payment goes to principal and, on payment No. 360, the slate is wiped clean.

In a nation obsessed with cents-off grocery coupons it is a little baffling how placidly the American home buyer accepts this sort of lopsidedness.

Well, some say, it’s only money and (a) we’re not going to stay in this house 30 years, anyway, or (b) a good chunk of it is tax deductible, or (c) the house is going to appreciate in value, anyway, and inflation will even things out, so what’s the big deal?

Value of Deductions

Maybe. Maybe not. But no tree grows to the sky, even in Southern California, and nonstop equity-growth-through-appreciation could be a dangerous assumption.

Don’t accelerate because of the tax impact? On a $75,000 mortgage (10% for 30 years), if you’re in the 28% tax bracket and accelerating your payoff $25 a month, you’d pay only $14.12 less in interest the first year--a $3.95 loss in tax deductions.

While accelerating the payoff of your mortgage is obviously no substitute for a long-range investment plan, it’s relatively painless, the savings in mortgage interest are awesome and there’s something very appealing in having monthly mortgage payments off your back 12 or 15 years down the road.

There are four popular techniques for the fast payoff of a mortgage:

1. The 15-year mortgage. Contrary to first impressions, taking on a 15-year, instead of a 30-year, mortgage doesn’t double your monthly payment, but increases it about 20%. In the case of a $100,000 mortgage at 10.5%, for instance, the monthly payments spread over 30 years are $914.74. Over 15 years, they are $1,105.40, or $190.66 more a month.

Interest saved by cutting it to 15 years: $130,333.

Disadvantages: A necessarily higher income to qualify for the 15-year mortgage, and you’re locked in to those higher payments for the full 15 years unless you refinance later.

2. The Canadian, or payday, mortgage. Devised by Canadian credit unions several years ago for their members who were paid biweekly (26 times a year), this type of mortgage is stimulated by the fact that mortgage interest is not deductible in Canada.

Instead of deducting the member’s mortgage payment once a month, the Canadian plan deducts half the monthly amount due each payday and, since there are 26 paydays a year, the effect is roughly that of making one additional full payment a year.

Depending on the interest rate and the size of the mortgage, this simple technique will normally cut a 30-year mortgage down to about 20 or 21 years.

Disadvantages: Since it requires the electronic transfer of funds, lending institutions offering it are limited.

Hint: Roughly the same effect can be achieved by simply making one extra monthly payment once a year.

3. The principal-only acceleration. This has an instant appeal because, at least for the first few years, the bite is minimal--you simply make your regular monthly payment and attach to it a second check for the next month’s principal, and each time this is done one additional month is knocked off the life of the mortgage.

By following it faithfully, the 30-year mortgage is paid off in 15 years. In the case of this $100,000 mortgage at 10.5%, for 30 years, here is how the $914.74 monthly payment is broken down for the first five months:

PRINCIPAL-ONLY ACCELERATION

Month Interest Principal No. 1 $875.00 $39.74 No. 2 $874.65 $40.09 No. 3 $874.30 $40.44 No. 4 $873.95 $40.79 No. 5 $873.59 $41.15

Thus, with your first monthly check of $914.74 you attached a second check marked “principal only” in the amount of $40.09 (No. 2) and with your next check for $914.74 you add a second one for $40.44, and so on.

Disadvantages: The bookkeeping can get a little confusing and along about the eighth year (which is the equivalent of the 16th year of a 30-year amortization) the principal-only payments are becoming more burdensome--not $40 or $41 a month, but about $209 or $210 a month.

4. The unstructured, but consistent, flat-sum acceleration each month. Some flat amount is paid at the same time the regular monthly payment is made: an extra $25, $50, $100 or $150 a month.

Here’s how this system impacts the same $100,000, 10.5%, 30-year mortgage:

FLAT-SUM ACCELERATION

Acceleration Payoff Interest per month in years saved $25 25.6 $40,783 $50 22.7 $66,309 $100 19.0 $98,377 $150 16.5 $118,502

Disadvantage: It takes a whale of a lot of will power. The whole acceleration business is unglamorous and there are those who will argue with great fervor that that extra $150 a month could be better spent on a good mutual fund.

Sure, if the compounded yield on the fund exceeds the mortgage interest, and if there’s no repetition on Wall Street of the events of October, 1987.

Or, in Mother’s case, October, 1929.