Tips from Real Life 101

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Posts Tagged ‘financial planning

3 Reasons NOT to Pay Off Your Mortgage Early

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With the current housing crisis, many homeowners are considering paying extra each month on their mortgage to pay their loans off early.  People work hard every month to come up with extra dollars looking for big savings in the future.  But is it really worth it?

Let’s look at the facts:

The case for:

(The numbers in the following example were created using a mortgage amortization worksheet template which may be found online or in the spreadsheet software that came with your computer.)

The case for paying off your mortgage early is usually explained as follows:

Assume you have a 30-year mortgage for $100,000 at fixed 4.75% APR.  Your monthly payment – excluding taxes, insurance, etc. – would be $521.65.  By the time you pay off your mortgage 30 years later, you would have paid a total of $87,793 in interest.  Instead, you opt to pay an extra $100 a month towards the principal on your loan.  This extra amount reduces the interest you pay to $59,351 and causes your loan to be paid off 102 payments early.

Your total savings are $28,441:

$187,791 (total payments expected with original loan) – $159,350 [($521.65 + $100 extra payments) x 257] = $28,441

What could be wrong with that?

The case against:

As attractive as those numbers look, there are several issues which makes this less of a good deal than you might think.  Let’s look at them in detail.

1) How long will you live in your home?

Studies show that, on average, people tend to change houses every 5 to 7 years.  If you don’t plan on living in your house for the next 30-plus years, there is no financial advantage to paying ahead on your mortgage.  All the extra money you pay each month will be returned to you when you sell the house.  It’s kind of like getting a tax refund; it feels like a bonus, but you’re just getting your own money back at a 0% rate of return (more on that later).

2) Don’t forget inflation.

The savings you achieve by paying extra on your mortgage don’t happen all at once, but rather over time and in the distant future.  In this case, paying an extra $100 on our mortgage starting in month 1 causes us to stop making payments in month 257 – over 21 years later.  We know that we live in a world where inflation is a reality: the purchasing power of our money decreases at some rate over time.  However, many people who argue for paying extra on a mortgage are treating the money they get back 21 years in the future as having the same purchasing power of today.  Unfortunately, their values are quite different.

In the U.S., inflation has increased at an average rate of 2 – 3% yearly.  If we assume an increase in inflation of 3% per year, our $521.65 mortgage payment 21 years from now will be equivalent to a payment of $276.30 today.  By year 30, that value has dropped to $212.02.  Put simply, we are paying $100 to save around $250, not $521.65.  If we inflation-adjust the extra payments over time and the total savings over time, the net present value (how much paying extra saves in today’s dollars) equals $6,030.61 ($24,969 in savings – $18,938 in extra payments).  That’s a lot of extra work for not much return.

3) Your extra payments earn a 0% rate of return.

This is probably the most important point people overlook.  Every extra dollar you spend paying down your mortgage early earns you no money in return.  The value of your home increases or decreases based upon changes in the housing market, not how much money you put into your mortgage each month.  Let’s say you opt to put the extra $100 each month into an investment product which earns an average annual return of 8%.  By the end of 30 years, you would have accumulated about $148,015 in your investment fund.  Compared to the $87,793 you paid in mortgage interest over this period, you are $60,222 ahead.  Not only do you have more money, but this gives you cash you can access over those 30 years should you need it for medical bills, emergencies, or other unexpected expenses.  If all your money is tied up in your house, you will have to sell it, or take on more debt, to get access to the cash.

Is it never a good idea to pay off a mortgage early?

There are some circumstances in which paying your loan off early makes sense.  For example, if you are nearing retirement, you may want to pay extra so you don’t have a mortgage payment to contend with every month.  If paying your loan off takes five years or less, the effects of inflation and potential investment earnings are negligible, so you aren’t doing yourself a disservice.  Also, if you pay private morgage insurance (PMI) on your loan, and your loan originated before the tax law changed to make PMI payments tax deductible, there may be an advantage to paying ahead until you’ve created enough equity to eliminate those extra payments.

What should I do instead?

Invest your money.  Time is your best friend or your worst enemy when it comes to investing.  Don’t use the next 20 or 30 years paying extra on a mortgage when you could be doing something that can create real economic benefit for yourself.  Increase your 401(k) withholdings at work, or open an IRA account.  Contribute extra to your child’s college education fund, or add to your cash reserves, so you don’t have to rely on debt during tough times.

A great way to get ahead on your mortgage is to look into refinancing options.  In our current, low-interest rate environment, it may be possible to refinance a 30-year loan into a 20- or 15-year loan without increasing your monthly payment.  The lower interest rate and shorter time horizon will reduce the total interest paid on the loan without tying up any extra cash.  For example, let’s assume you started with a 30-year, $100,000 fixed rate mortgage at 5%.  After five years, you would have a loan balance of $91,282 and be expected to pay out $69,601 in interest over the next 25 years.  If you refinance that loan into a 20-year fixed at 3%, not only would you pay your loan off 5 years earlier, but your monthly payment would be $26 less each month, and you would pay $39,152 less in total interest.

Like any decision, there are many factors that influence how we spend our money.  It is important to consider all your options before committing your hard-earned extra money to your home loan.  By anticipating how long you will live in your home, and understanding what investment or refinancing options are available, you can make the best choice for how to handle paying off your mortgage.

Written by Real Life 101, Inc.

January 31, 2011 at 12:44 pm

10 Tips for Keeping Your New Year’s Financial Resolutions

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I know what you’re thinking – another New Year’s resolution article.  I promise this one will be different.  Every year we read one of these articles, and we get excited about making this year the one where we really take care of business.  This will be the year we finally get a handle on our finances.  However, by February or March we are back where we started from without any trace of optimism.  But this year can be different if we set ourselves up for success.  We’ve created ten tips to help put you on the right path and keep you there all year.

10. Pick something important to YOU.

The big reason most New Year’s resolutions fall flat is it’s too easy for us to give up.  Choose an area of your financial life that will make real, meaningful impact.  Perhaps you are overburdened by credit card debt, or maybe you are concerned about paying for your child’s college education.  Determine your biggest pain point, and address it head on.  If you can’t afford to ignore it, you will be less likely to abandon to the plan.  Financial problems are like cavities in teeth; they don’t get better by themselves, and the longer you wait to address the problem, the bigger the hole you have to fill.

 

9. Be specific.

When creating your resolutions, be specific in what you intend to accomplish.  It’s not enough to say, “I want to have less credit card debt,” or, “I want to save more for retirement.”  Goals like these are recipes for failure.  How much is less or more?  If you want to create meaningful change, set a specific, measurable goal. Paying off three of your credit cards or putting $10,000 toward your retirement are specific goals which can be easily measured.  You can track your progress through to achievement and know you’re making a meaningful impact on your financial life.

8. Run the numbers.

When setting a financial goal, do the math, and figure out what it will take to achieve your goal.  This helps you create a financial “roadmap”: you’ll know where you’re going and how you’re going to get there.  Don’t be discouraged by a big number; break down the total amount into monthly or weekly sums.  Focus on achieving the smaller, incremental numbers,  and over the course of the year, you will achieve your goal.

7. Incorporate change into your daily routine.

Once you know what you need to do each month or week, determine how that change will affect your daily routine.  For example, you may determine that you can save the $5 per day you need by skipping your morning latté.  Maybe another $20 comes from eating an extra meal in every week.  Whatever it is, make the commitment, and recognize the financial  impact every time you take action.  Think of it as an affirmation; “Paying off my credit cards this year is more important to me than having a latté today.”  It’s easy to lose track of the big picture when we get caught up in the moment.  By actually pausing to remind yourself why you are making certain choices, you are less likely to get derailed.

6. Phone a friend

Don’t feel like you have to do this all by yourself.  Share your goal with friends who are looking to make similar changes.  Talk regularly about your successes and challenges.  This will have several benefits.  You will feel more accountable to achieve what you set out to do and be less likely to give up.  Also, you will find that others will suggest ideas and strategies you  may not have considered as well as offer words of encouragement when you need them.

 

 

5. Win the little battles

Spending less is the obvious answer to how to find more money to put toward your financial trouble spots.  The answer which isn’t so obvious is where that money will come from.  With a little creativity and discipline, everyone can find ways to keep more money in their pockets.  Always remember – small, continuous efforts add up to big results.   With apologies to Benjamin Franklin, “a penny saved is a penny we can use to address our financial troubles.”  Here are some hints for finding extra funds.

Analyze – Look at your financial challenge, and make sure you are positioning yourself for success before you get started.  If you are paying off credit card debt, have you tried to negotiate a lower interest rate with your creditors?  Have you looked at a balance transfer to another card with a lower interest rate?  Have you explored a debt consolidation loan?  You may find a favorable circumstance which makes your problem more manageable than you initially thought.  Next, look at your spending habits, and see what stands out to you.  This is an eye-opening experience for most people when they discover some random category accounts for an unreasonably high percentage of their total spending.  Attack this area first, but evaluate all areas of your budget to see where savings can be found.

Eliminate wasteful spending – This is huge regardless of what your goal may be.  How much food do you throw out every week?  How many gadgets do you buy which end up on your shelf unused?  Be aware of every dollar you spend, and make sure you are getting maximum value in return.  For example if you know you are bad with leftovers, make a smaller portion, or freeze part of what you make.  Try not to pay full price for anything.  Retailers and manufacturers are competing harder than ever for your business; use this to your advantage.  Look for sales, closeouts, coupons, and other specials to stretch your dollar.  A little extra effort in your shopping can put a lot of extra money back in your pocket.

Economize – Cutting out isn’t the only way to generate funds; sometimes we can just cut back.  Spending $5 less a day puts an extra $1,825 back into our pockets every year.  Challenge yourself to find ways to trim a little bit out of your daily spending.  Getting a medium latté over a large may save $1.  A smaller size popcorn at the movies may save another dollar or two.  Have water instead of ordering a drink at a restaurant and save $3 or more.  These small changes add up to big dollars over time.

Downsize – If you need to be more aggressive in curtailing your spending, downsizing can be a good option.  Are you using all of the minutes you pay for on your cell phone, or is there a cheaper plan which can still meet your needs?  Some changes can have a domino effect.  Organize a carpool at work, and not only will you spend less on gas, but since you will put fewer miles on your car, you will spend less on maintenance and even car insurance.

Prioritize – Bigger goals call for bigger actions.  This means we have to give up things which are less important to us than achieving our resolutions.  What is more important to you, having premium cable channels or paying off your credit cards?  Which is more important, a new boat or starting a college fund for your children?  Remember, the more financial burdens you eliminate, the more money you free up for the fun stuff.  Put another way, if we don’t take care of our financial challenges first, we will never be in a position to comfortably afford the things we want to spend our money on.

 

4. It’s all about value

When making purchases, it’s easy for us to get fixated on price and lose track of value.  Consider shopping at a wholesale club.  The unit price of an item may be better if we buy in bulk, but we may end up buying way more of something than we can use.  That’s not a better value.  Try sharing the cost of a bulk purchase with friends, so each person ends up with the amount they need while still enjoying the cheaper unit price.  Does it have to be new?  With sites like eBay and Craigslist, many products can be found in excellent condition at a fraction of the cost retailers charge for new items.  Do you have to buy it?  Many items – like tools and equipment – may be rented at a fraction of the cost of purchasing.

3. Find it for free

Challenge yourself to find free or low-cost alternatives to some of your more costly budget items.  Instead of renting a movie, try your local library; if the title came out more than 30 days ago, it’s likely they have a copy.  There are over 1.8 million free e-books available for download from Amazon.com.  Most cities have free public events, concerts, art exhibits, and more taking place every day.  There are many more events which have only a nominal fee relative to other sources of entertainment.  Not only does it help you save money, but it helps connect you to the culture in your local community.

2. Believe in yourself and your ability to affect change

Many people fail in their resolutions because they believe their problems are greater than themselves.  We need to remind ourselves that solving our financial crises is like creating a sculpture.  We have to chip away at them day after day, month after month, until we achieve our end result.  There is no quick-fix solution to these problems; it took time to get into this position, and it will take time to get out of it.  But even the smallest change can have a measurable result.  By paying as little as $10 a month extra against a high credit card balance, you can save yourself tens of thousands of dollars in interest.  Once you figure out where you’re going, and how you’re going to get there, it’s just a matter of doing it.

 

1. Don’t just treat the symptoms – cure the disease

Accomplishing your resolution is an important first step, but the real challenge is to recognize and address what got you to this point in the first place.  Were you trying to live beyond your means?  Did you underestimate what kind of financial reserves you needed for emergencies?  Whatever the case, be honest about what got you to this point, and make a conscious effort to change that behavior.  Let the discipline you used to get out of trouble help keep you from making the same mistakes twice.

Written by Real Life 101, Inc.

January 3, 2011 at 6:02 pm