Should I Make Extra Principal Payments On My Mortgage
As mortgage interest rates start to rise, you may wonder if it’s better to pay your loan off faster by making extra principal payments. In this post, we’re going to answer this very question.
Here’s how this post is broken down:
- What are the tradeoffs we make when making extra principal payments
- Does it make sense to make extra principal payments (Analysis)
- Conclusions and takeaways
What are the tradeoffs we make when making extra principal payments?
When we take out a home loan we have to pay a mortgage every month. Part of that mortgage goes towards paying off your home. Another portion of it goes directly to the bank as an interest payment – think of this as a fee we pay to the lender for letting us borrow their money.
Benefits
Most lenders will give us the option to make additional principal payments. These are the benefits of making extra principal payments:
- Over time the extra principal payments will reduce your loan duration and allow you to pay off your home faster.
- Paying off your home faster frees up cash in the future for investments in the stock market
- Paying off your home faster will also reduce interest payments you make to your bank over the life of the loan
Costs
The drawback to making extra principal payments is that we could have used that money to invest in other assets, such as stocks. Even saving small amounts over a long time in index funds can add up.
Does it make sense to make extra principal payments (Analysis)
In this section, we will compare the benefits to the costs by looking at how much we would save in interest and mortgage payments versus how much we could accumulate in the stock market.
Here are a couple of factors I will be using in this analysis:
- The home we buy costs $1,000,000 and we have a 20% down payment – this means our loan amount is $800,000
- We have a 30-year fixed interest loan.
- We will use three different interest rates: 3%, 5%, and 6%
- We will assume that an index fund similar to the S&P500 will average 7% annual returns
- We will make $500 in extra principal payments every month
Scenario 1
An $800,000 loan with a 3% interest rate, and we pay an extra $500 every month on top of our monthly mortgage payments.
| Total Interest Saved | Return on Mortage Saved | Total Stock Portfolio Value | |
| Year 1 | $69.27 | $0 | $5,696 |
| Year 15 | $23,486.34 | $0 | $159,406 |
| Year 30 | $87,315.15 | $290,559.82 | $617,626 |
- In the first year of our loan, we will save $69 dollars in interest payments
- If instead, we had put $500 a month in the S&P our stock portfolio would be worth $5696.
- By year 15, we would have saved a total of about $23k in interest payments
- If instead, we had put $500 a month in the S&P our stock portfolio would be worth almost $160k.
- By year 30, we would have saved $87k in interest payments. Also, we would pay off our home 5 years faster. This would allow us to invest our monthly mortgage amount into the stock market and save an additional $290k.
- If instead, we invested $500 a month into an index fund that returns 7% annually we would net $617k by year 30
The best decision in this scenario is to put money in the stock market instead of paying off our home faster. Because our interest rate is low (just 3%) we will benefit more if the money is put into an index fund that tracks the S&P.
Scenario 2
An $800,000 loan with a 5% interest rate, and we pay an extra $500 every month on top of our monthly mortgage payments.
| Total Interest Saved | Return on Mortage Saved | Total Stock Portfolio Value | |
| Year 1 | $116.03 | $0 | $5,696 |
| Year 15 | $43,644.47 | $0 | $159,406 |
| Year 30 | $175,939.77 | $402,607.26 | $617,626 |
- In the first year of our loan, we will save $$116 dollars in interest payments
- If instead, we had put $500 a month in the S&P our stock portfolio would be worth $5696.
- By year 15, we would have saved a total of about $43k in interest payments
- If instead, we had put $500 a month in the S&P our stock portfolio would be worth almost $160k.
- By year 30, we would have saved $175k in interest payments. Also, we would pay off our home 5 years faster. This would allow us to invest our monthly mortgage amount into the stock market and save an additional $290k.
- If instead, we invested $500 a month into an index fund that returns 7% annually we would net $617k by year 30
In this scenario, the total interest saved ($175k) combined with the return on mortgage payments we can avoid by paying off the loan faster ($402k) is now pretty close to the return we can make in the stock market. If our interest rate is 5% we should ask ourselves a couple more questions to decide which is the better route:
- Am I going to be disciplined in saving money in the stock market – If you are worried about market ups and downs and you think you won’t be a disciplined saver then you’re better off putting the money into extra principal payments.
- Will I need money down the road for something else – If you want to have a nest egg so you can start a business or fund some other venture, it’s best if you don’t put extra money towards paying off your home faster. You can’t extract the extra principal you paid on your home, but you always sell your stocks.
Scenario 3
An $800,000 loan with a 6% interest rate, and we pay an extra $500 every month on top of our monthly mortgage payments.
| Total Interest Saved | Return on Mortage Saved | Total Stock Portfolio Value | |
| Year 1 | $139.58 | $0 | $5,696 |
| Year 15 | $55,409.36 | $0 | $159,406 |
| Year 30 | $232,111.85 | $472,041.12 | $617,626 |
- In the first year of our loan, we will save $139 dollars in interest payments
- If instead, we had put $500 a month in the S&P our stock portfolio would be worth $5696.
- By year 15, we would have saved a total of about $55k in interest payments
- If instead, we had put $500 a month in the S&P our stock portfolio would be worth almost $160k.
- By year 30, we would have saved $232k in interest payments. Also, we would pay off our home 6 years faster. This would allow us to invest our mortgage amount into the stock market and save an additional $472k.
- If instead, we invested $500 a month into an index fund that returns 7% annually we would net $617k by year 30
In this scenario, the total interest saved ($232k) combined with the return on mortgage payments we can avoid by paying off the loan faster ($472k) is more than we stand to get in the stock market if we assume a historic return of 7%. Paying off your home faster is the best decision in this case.
Conclusions and Takeaways
- Whether or not you should make extra principal payments towards your home mortgage depends on the interest rate you have. If we consider that the long-term average return of the S&P Index is 7%, we should make extra principal payments if our interest rate is 6% or greater.
- If you have an interest rate between 4% and 5% and you’re not a disciplined saver, you just want to pay off your home faster, or you don’t want to deal with the ups-and-downs of the market put extra money towards additional principal payments
- If you have an interest rate between 4% and 5% and you’re thinking you’ll need the money for some other venture down the road, save the money in the stock market, and don’t pay off your home faster than you need to.
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