Is overpaying on a mortgage a good idea?
It might seem useless and counter-intuitive to overpay on a mortgage. But after a bit of brainstorming about it, overpaying make a lot of sense.
But it is not that easy. You need to think and analyze long and hard whether you should overpay on your mortgage or use that money elsewhere. Still, it is all tied up in the end to calculating a bunch of numbers and see if you are willing to take a risk.
How is a mortgage calculated more precisely?
Your mortgage loan is divided into monthly loan installments which consist of principal, interest, real estate taxes, and mortgage insurance(insurance applies if the down payment is less than 20% of your home’s purchase price).
A high interest rate translates into more money allocated towards the interest portion of your mortgage. The opposite, however also applies. Once you made a mortgage payment, the portion dedicated to principal grows while the one dedicated to interest shrinks. Monthly, the interest rate is recalculated based on the remaining loan amount.
Are there any advantages to overpaying on a mortgage?
Of course they are, paying it earlier can give you a lot of benefits.
Lower the amount of interest that you will pay. When you overpay on a mortgage, all the extra money added to your payments gets directed towards the principal of the loan. Because of this, your interest rate will get lower faster.
To put that into perspective, if you would have a 30 year fixed-rate mortgage consisting of 300.000$ at a rate of 4%, by the end of the mortgage’s life you would pay around 215.600$ towards interest. If you were to pay an extra 300$ monthly, by the end of your mortgage’s life, the total interest value would be around 148.215$. That is a savings of around 67.385$!
Also note that the extra money is added towards the principal portion only. You won’t add a single cent towards the interest.
End the mortgage faster. Using that example, not only that your interest will be reduced significantly, but the mortgage will end 8 years and 5 months sooner.
Build equity. when you pay towards the principal of the loan, your home builds equity by default. When you save interest on a mortgage by paying extra on your monthly mortgage payments, the equity savings in your home grow each month. This equity can later be used for a refinance or when you decide that it is time to sell your property.
Are there any disadvantages of overpaying on a mortgage?
Well not everything is sunshine and rainbows, there are some disadvantages, but they are there if you consider them a disadvantage.
Paying money towards overpaying when you could invest them elsewhere. Because the interest rates towards mortgages haven’t been so low, many homeowners think that it is a good idea to use that money elsewhere.
This only works if the interest that you are getting from that investment is larger than the interest that you will pay towards your home mortgage.
Again, to put into context we will use the same example: a 30 year fixed-rate mortgage of 300.000$ with a 4% rate. If those 300$ were invested into something that granted you 8% returns, you could end up with 425.000$ if they stay constant. On top of the 108.000$ that you invested over that 30 year period, you would acquire over 316.000$ in interest.
But, there is also the risk. That 8% rate might not be set in stone and it can decrease if the market fluctuates.
Lack of diversification. Many people have only their home as a major asset in their life. If you pay your mortgage off earlier, you are not getting any more assets, you just become debt-free sooner.
Minimizing tax breaks. When you pay your mortgage off sooner, you got less money on your hands from tax deductions. Tax money which is saved through deductions from your mortgage can turn into a very large chunk of money. When you overpay, this effect gets reduced and might lose you a bit of money in the long run.
Also you should know that if you decide to extend your mortgage in order to invest money elsewhere is risky. If you know what you are doing and you are confident in investing the money elsewhere is a good idea then go for it. You certainly don’t want to lose your home because you decided to take a risk.