Put This Mortgage Industry Truism to the Test
Prepayments may still be a valuable option for clients who can’t afford shorter-term loans
By Hiroshi Hishida, owner, North Star Capital Management LLC
| July 2019
The internet introduced the world to the concept of the life hack. It showed people ways to live a more efficient life, such as tying extension cords together to keep them plugged in or burning Doritos to start a campfire.
Long before these were a thing, the mortgage industry had its own method of helping people live a better life, a strategy that originators often shared with clients: Make one extra payment a year and shave seven years off a 30-year fixed mortgage while saving tens of thousands of dollars in interest payments. There are variations on this theme, but the simple idea is that extra payments pave the way for owning a home outright years earlier.
For decades, the idea proved popular with borrowers who worried about being tied to a mortgage for most of their adult lives, as well as mortgage professionals working with hesitant clients who might not have been able to afford a shorter-term loan. In this time of low interest rates, does this industry truism still have merit? Can borrowers cut that much time off their mortgage by making an extra once-a-year payment? And what does this mean for borrowers, mortgage brokers and loan officers?
Do the math
Let’s take a look at the numbers. For this exercise, consider a $400,000 home with a 30-year fixed mortgage and an 8 percent interest rate with a monthly payment of $2,935.06. Interest rates generally averaged higher than 8 percent from the 1970s through 2000.
With regular payments, a homeowner will end up paying $656,621 in interest over 30 years for a total cost of more than $1.056 million for that $400,000 home. If the borrower made just one extra payment a year, however, they would pay off the mortgage in 23 years and one month while paying $479,967 in interest. That equates to paying off the mortgage nearly seven years early and a savings of $176,654.
Another variation would be to add an extra 1/12th payment each month, or about $244.59 with each bill. That would pay off the mortgage in 22 years and 11 months for a savings of $183,633 in interest payments. The loan is paid off slightly faster because the extra payments are applied over the course of the year, reducing accrued interest.
These options would be incredibly appealing for many clients. But there’s an obvious problem with this exercise: Interest rates aren’t 8 percent anymore.
In the past, interest rates were significantly higher than they are in today’s market. A 30-year fixed mortgage rate averaged 12.7 percent during the 1980s, according to data from Freddie Mac. In the 1990s, the interest rate for 30-year mortgages averaged 8.1 percent. Prior to 2002, interest rates never dipped below 6.5 percent during a single month.
Since then, however, interest rates have spiraled downward, making it easier and more affordable for most Americans to buy a home. Now, interest rates range between 4 percent to 5 percent. The Fed does not appear likely to increase rates this year, meaning borrowers are likely to continue to benefit from a low interest environment in the coming months. And that changes what happens to the sample home transaction quite a bit.
For the modern-day scenario, let’s consider a homebuyer who is looking to pay off a 30-year, $400,000 mortgage at a 4.5 percent interest rate. This person is making payments of $2,026.74 per month.
With regular payments, the borrower will pay $329,627 in interest for a total of $729,627 for that $400,000 home. By making an extra payment every 12 months, the borrower pays off the 30-year mortgage in 25 years and nine months, shaving a little more than four years off the term. This borrower will save $53,397 in interest payments.
An extra 1/12th payment each month would reduce the time to 25 years and eight months while cutting $55,390 in interest payments. It’s easy to see the real dollar difference between an 8 percent interest rate and a 4.5 percent rate.
With lower interest rates these days, the impact is not as dramatic. So, is the concept of an extra payment per year dead? It shouldn’t be.
Explore the options
Part of the job for mortgage originators is making their clients understand options. And this is a choice that should still be appealing to many borrowers.
A 15-year or even a 20-year fixed mortgage are daunting options and ones that many borrowers simply cannot afford. Clients’ eyes often widen once they see how much interest they will pay on a 30-year mortgage.
Helping them understand what an additional payment can achieve is a way for clients to plan better for their future. Even with interest rates at 4.5 percent, there’s a significant savings in cost and time.
By having a home paid off four years early — and saving more than $50,000 on the term of the loan — the borrower can use that extra cash to help a put a child through college, travel to bucket-list destinations or even retire early. All that it takes is a little pain early in life.
Planning to pay extra on a mortgage instead of getting a shorter-term loan, such as a 15-year fixed mortgage, also gives the borrower more flexibility. They can always skip an extra payment if their budget is tight.
Drawbacks to consider
When advising clients, originators also should lay out the possible drawbacks of mortgage prepayments. By doing so, originators will educate the borrower and potentially earn repeat business or future referrals.
One of the downsides, for example, of paying off a mortgage early is that the borrower may pay more in taxes due to a reduced mortgage-interest deduction. This, however, will not be as much as the interest that would have been paid over time.
It is important to consider the opportunity cost of using funds to pay off a mortgage instead of saving or investing elsewhere, especially with retirement funds that have potential tax benefits and possible employer matches. Borrowers also should consider establishing some savings for emergencies.
Originators should lay out to the client whether the lender charges any fees for extra payments or for something other than principal-only payments. Also, the originator should help the client understand how to earmark extra payments to be applied to the principal. While the extra-payment-per-year trick might not be the life hack that it once was, it’s still a shortcut that homeowners will want to consider.