Mortgage Payoff: Lump Sum or Monthly?

by Kevin on March 5, 2009

When we bought our home we didn’t have 20% to put down. We were unknowingly in the middle of a real estate bubble. Yet we wanted to be smart and buy a home that we could easily afford. Our goal was to be below a rough 30% payment-to-income threshold for the house payment. We were especially lucky that we did not have additional debt coming into buying a house, so this would be our sole debt.

Thus we put 5% down on the house and got a 15% second mortgage to cover the balance from 80% on up. We can easily afford the payments and have actually been paying about a month early — a great layer of protection if we need it.

Was it the wisest decision to not wait until we had 20% to put down? I’m not sure. Only time will tell. As I have said several times while writing on this blog every situation is different. We knew what we were getting to upfront — we will pay higher interest costs than we would normally. But we wanted the house, we could afford the house quite easily, so we pulled the trigger and bought it.

I wouldn’t outright recommend everyone only put 5% down on a home (and good luck doing that these days anyways). It works for us because we have significant savings and significant cash flow at the end of every month. This is money that can go toward our savings snowball and if we need it to, to paying off the house faster.

Yet, we have a second mortgage. And it has started to bother me lately especially with the economy in shambles. I thought perhaps we should try to knock it out as quickly as possible and then apply what was our second mortgage payment to our first mortgage in an attempt to pay off the house very quickly.

What is the Best Way to Pay Off a Mortgage

With a new goal of paying off the second mortgage as quickly as possible, I began to ponder the different ways you can pay it off.

I came up with two methods:

  • put every extra dollar left at the end of every month toward the loan — just like you would with any other debt
  • put every extra dollar left at the end of the month in a savings account, save up the balance of the mortgage, and pay it off in one lump sum

Mathematically speaking, the first method is definitely the best method. The additional principal you pay every month reduces your long term interest immediately. This saves you the most money as possible.

In the past I’ve said I don’t buy the whole “managing your money is 80% psychological” that Dave Ramsey promotes. And I still don’t. With credit cards I have focused on the benefit of paying off the highest interest cards first rather than the smallest balances (psychological “wins”) first.

In this instance I am going to disagree with the best method from a mathematical standpoint.

But that doesn’t mean I’m buying into the psychological viewpoint either.

Saving Up to Pay Our Mortgage Off in a Lump Sum

No, the reason we are going to switch strategies (again!) to saving up a lump sum is due to the economy. The money that we have left at the end of every month will be swept into a savings account category specifically to be used to pay off the 2nd mortgage. Over time the fund will build up and we can pay off the mortgage all at once.

As the fund builds up it can act as an additional emergency fund for us. Hopefully we won’t need to use it — but if we did, that extra money will be sitting there to help us out. If either my wife and I lost our job, I would much rather have money sitting in a bank account than increased equity in our home. Equity can’t pay the bills. Money in a savings account can.

The Lump Sum Tradeoff

With the lump sum method you are trading lower interest costs overall to a margin of safety. I think this cost is worth it during these scary economic times. At the end of the day you are paying off the mortgage a lot faster than your normally would.

In our instance, if we saved up the extra money that we are anticipating having every month for 68 months and then paid a lump sum our total interest costs would be $14,968.

If we paid that extra money every month instead, our interest costs would drop to $9,398.

That’s a difference of $5,570. That’s big money where I come from, but imagine having that money in equity and not in cash. That could be an even bigger problem if an emergency hit.

Of course we may adjust our strategy again in the future. Being flexible is key with your finances. We may switch to where we save up the money every year and put 1/2 of it toward the mortgage at the end of the year. We’ll see. For now, we are switching to the lump sum method.

Hey Homeowners: Are you paying off your mortgage faster than normal? How are you doing it? Leave a comment and get the discussion rolling.

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