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What Every Homeowner Should Know Before Paying Additional Principal To The Mortgage

2007
11.30

Have you ever thought about your Freedom Point?

“Freedom Point” is one of the more important concepts in mortgage planning and yet it gets surprisingly little attention.

As its name implies, Freedom Point is the particular date when a homeowner's liquid assets exceed his debts. At the Freedom Point, paying off a mortgage transforms from an obligation to a strategic financial planning decision.

My duty as a Mortgage Planner is to help my clients reach their Freedom Point as quickly and efficiently as possible. I achieve this by helping homeowners to make informed liability and mortgage decisions.

In my playbook, there are two very basic — and very different — approaches to accelerating a Freedom Point.

  1. Prepay the mortgage by sending extra principal payments to the bank monthly, or annually
  2. Leverage a “low payment” mortgage program and then invest the difference between the low payment and the payment of a 30-year amortized loan in an interest bearing account

Let’s look at Method #1 in a chart:

The Mortgage Coach : Prepaying a mortgage helps pay the loan off faster

In Method #1, a homeowner pursues a safe and predictable plan of attack on his $400,000 home loan. By over-paying the mortgage each month by $250 (as shown in the “30 Yr Redux” column), the 30-year fixed mortgage is paid in full and the homeowner reaches his Freedom Point in 23.3 years.

In eliminating 6.7 years off the mortgage, the homeowner saved $131,788 in mortgage interest payments.

Not too shabby!

Now, using Method #2, the homeowner uses a low-payment mortgage such as a 5-year ARM with interest only payments, or a 30-year fixed mortgage with 10-year interest only payments. But, he also calculates what the “full” mortgage payment would be if the loan was not interest only.

The difference in the two payments is invested and then managed in interest-bearing accounts.

In other words, instead of paying principal to the mortgage company, the homeowner pays the principal to himself and earns interest on it.

Let’s look at the chart for Method #2:

The Mortgage Coach : You may reach your Freedom Point more quickly by making interest only payments and investing the principal

In financial terms, this is called “compounding” and is the main reason why money in the bank is better than money under your mattress. The longer the bank holds your money, the more interest it earns over time.

Because of compounding interest, the homeowner using Method #2 reaches his Freedom Point in just 22.6 years.

Why Method #2 may accelerate the Freedom Point is a matter of simple mathematics. If properly managed, the homeowner's accumulation fund will earn interest, and then the interest earned will itself earn interest.

But there’s an additional benefit for homeowners using Method #2.

Having an “accumulation fund” provides additional liquidity. With money sitting in a bank account (and available at a moment’s notice), a homeowner has more financial options in the event of a life emergency such as job loss or illness.

By contrast, extra principal paid into a mortgage is not recoverable without a remortgage.

And now it gets interesting.

Once a homeowner reaches his Freedom Point using Method #2, he holds power over his finances and is leveraging his home to the fullest. Because a properly-managed interest-bearing account is virtually risk-free, the homeowner can now choose to:

  1. Use the accumulation fund to pay off his home in full
  2. Leave the accumulation fund alone and continue to earn compounded interest on it

These choices would not be available using Method #1. Remember, when a person pays extra mortgage principal to the bank, those dollars are considered “locked up” unless the homeowner chooses to remortgage his home.

So, which Freedom Point strategy is best for you?

It all depends on your personal savings discipline, short- and long-term goals, investment rate of return and current financial situation.

A key starting point, though, is to sit down with a qualified mortgage planner to do a Freedom Point Review. Annually, your mortgage planner should monitor your progress and help you to make adjustments to your plan, as needed.

Reaching your Freedom Point is all about goal-setting, having a plan, and making informed decisions. If you’re not confident that your current mortgage planner can help you make informed decisions to accelerate your Freedom Point, please call me or email me anytime.

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