When the calendar flips to a new year, many of us make resolutions to improve our lives. Judging by how busy the gyms get during the first three weeks of January, I’d bet that improving physical fitness is the most popular resolution, but improving one’s financial fitness is probably not far behind. To that end, today’s post will offer you a simple mortgage tip to help you lower your interest cost, pay off your mortgage more quickly, and prepare for higher rates at renewal.
Canadian mortgage rates are at record-low levels and there has never been a better time to put extra dents in your mortgage. The trick is to increase your regular payments by a relatively small amount to chip away at your principal over time, instead of waiting until you have saved up a chunk of money for a large extra payment (which for most of us tends to be a plan whose time never actually comes).
Most lenders will let you schedule an ongoing, automatic extra payment to be taken each time your regular mortgage payment is made, allowing you to ‘set it and forget it’. My advice is to calculate what your mortgage payment would be if your interest rate was 5%, subtract the amount you are currently paying, and use the difference as your extra payment.
Here is an example of how this technique would work if your current mortgage rate was 3.29%:
Monthly payment for a $250,000 mortgage at 5% (25 yr. am) = $1,454
Monthly payment for a $250,000 mortgage at 3.29% (25 yr. am) = $1,221
Difference = $233
Now, take a look at what paying an extra $233 per month will achieve over time, and remember that this example only assumes that you make the extra payment over the first five years (after that, I assume that you revert to paying the minimum).
Over the next five years this borrower will make an extra $13,980 in payments, save an extra $1,184 in interest cost, and knock off an extra $15,165 of principal by the time her mortgage comes up for renewal. But the real bang for each extra payment buck accrues over the longer term, because over twenty-five years the total interest-cost savings in this example grows to $14,276 (even though no extra payments are made after the first five years). That’s more than $1 in interest cost saved for each $1 of extra payment made, even with rates at record-low levels.
So why 5%, you ask? For starters, the average discounted five-year fixed-rate mortgage over the last ten years has been right around 5%, so when rates eventually rise from today’s ultra-low levels they will probably end up in that range. Building a 5% interest rate into your monthly expenses today will significantly reduce your risk of payment shock if rates are higher at renewal, as most experts predict they will be.
Also, 5% is high enough over today’s rates to make a difference to your bottom line while still being manageable for most budgets. (To see what your mortgage payment would be at a 5% interest rate, check my mortgage calculator.)
If you’re looking to improve your financial fitness in 2012, my advice is to turn the magic of 5% loose on your mortgage balance, and to steer clear of the gyms until early February when there are always plenty of workout machines to go around.
David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog (movesmartly.com) and on his own blog integratedmortgageplanners.com/blog). Email Dave