I admit I didn’t completely know what I was doing when I bought my first home. I really only knew it was going to be the most expensive purchase I’d ever make. It wasn’t until I saw the first monthly bill that I fully understood just how true that would turn out to be. After 9 years I saved $130,000 by paying off my mortgage early. Here I’ll explain exactly how I did it so that you can also achieve financial freedom.
Before getting into the details, the Mortgage Professor offers an invaluable spreadsheet for understanding mortgage loans, principal to interest ratios, interest totals, additional payments, and general what-if calculations. I highly recommend you download the Mortgage Professor’s Extra Payments Spreadsheet and input your own mortgage. It will make the rest of this article easier to understand.
Interest, interest, interest
It doesn’t take much time looking at mortgage payments before quickly realizing the amount paid in interest is astronomical. Even though I bought a modest home and had an initial interest rate of 5%, I was on track to pay as much as the price of the home in interest alone! Yikes! Although I had never planned to use all 30 years of my loan, seeing it in black and white really cemented my position. There was no way I was going to pay twice as much for my house. Instead I chose to pay it off as quickly as I could, so that I could earn the financial freedom I wanted.
Now, there are multiple schools of thought out there about interest. There is also an eternal debate about whether it’s best to pay off a mortgage early or invest. Some believe that if the interest rate is below the average stock market rate of return, which is 7%, then it is better to invest your money in stocks or index funds than to pay off debt with a lower interest rate. Others believe that paying off debt before doing anything else is the best approach. I went with a hybrid model.
How I Saved $130,000 in Interest
In the early years I paid down as much as I could because the majority of my mortgage payment went to interest. Although each monthly mortgage payment is comprised of both principle and interest, the ratio paid to each of these changes every month. The bank ensures they make money right away, so early mortgage payments are heavy on interest and light on principle. Payments at the end of the mortgage, 30 years in my case, are heavy on principle and light on interest. Because banks have the upper hand by being the lender, this structure favors them over the borrower.
While this structure is unfortunate, it does not spell doom for borrowers. Any additional dollars put towards the monthly payment above the minimum goes directly to principle. This shortens the life of the loan, which reduces the total amount of interest paid. This can be a difficult concept to understand. The best way to understand how this works is to play with the Mortgage Professor’s extra payments spreadsheet. Plug in some numbers into the green cells and look at how much the total interest and period columns change.
In my case, 78% of my first month’s mortgage payment went solely to interest! As far as I was concerned, I was paying a 78% interest rate, not the 5% in my mortgage contract. After my first year, I had already paid $8,509 in interest. After three years, I had paid over $22,000 in interest. It was clear that I needed to make a dent in my loan to shift more dollars to principle than interest.
I put any extra dollars towards my mortgage to further reduce the sting of interest. Ultimately, I saved $130,000 by paying off my mortgage early because I made these extra payments. Each year when I received a tax return, I applied it directly to my mortgage. If I received a company bonus, I put it straight to my mortgage. For those critical early years, any extra dollars were always applied to my mortgage. Without that discipline I would not be writing this article today.
Shifting to Investments
Once I had paid off about 30% of my mortgage and refinanced for a better interest rate (3.875%) I shifted my strategy to investments. I was still paying about twice as much in interest as I was principle, but there were other factors to consider. Although I couldn’t predict the future, the small amount I had invested in index funds prior yielded an over-performing 13% interest. Given that this was over a two year timeframe, it suggested there might be more positive gains ahead. My stomach had settled from the healthy dent I put in my mortgage over the past three years. I began paying the minimum mortgage payment and contributed any other savings to my index funds.
This strategy paid off. After three years investing in my index fund, I sold $60,000 and paid it towards my mortgage. If I never made another additional payment to my principle from that point forward, I would have only increased my total interest expense by $2,226 over the final six years of my mortgage. Recall that I paid $8,509 in interest in my first year alone.
Achieving Financial Freedom
As time went on I became more eager to achieve financial freedom. Thanks to my early planning, I was grateful to be in a position to pay off my mortgage with about five months of concerted effort at the end. I ultimately paid off my mortgage in exactly 9 years and saved $130,000 in unpaid interest. The weight had been lifted. I was officially free to make life decisions without worrying about how to account for ~$1000/month.
Through those 9 years, I paid a total of $41,196 in interest. Although it isn’t a perfect calculation, I look at the interest total the same way I would look at rent. Neither hold any residual value. They are just a monetary value for a temporary asset. If interest were rent, the $41,196 paid in interest amounted to $381/month in rent over those 9 years. It would be almost impossible to rent a place for that amount, so I consider my early mortgage payoff a financial success. What’s even better is that the longer I live in the same paid-off home, the better value my home becomes.
Now that I have addressed my biggest financial commitment, I have the freedom to live life as I choose. I can travel more than before, and I can leave my job without wondering how to pay my bills. I feel like I’ve unlocked a new chapter in life, and I have nothing holding me back!
Several months removed from my mortgage, I reflected on my decision to pay off my mortgage vs investing. Take a look if you’d like to hear about what I would do differently if I could do it again.