The secret financial strategy only the wealthy and prudent follow
Paying off debt early is a far superior long-term financial plan than continually adding to mortgage debt to support an extravagant lifestyle.
Most people believe they achieve the American Dream when they buy a house, but most often they only buy 3.5% to 20% of a house, not the whole thing. Although it feels like it’s their house, it’s not. If they quit paying the mortgage, the bank can take it from them, as millions found out during the housing bust. Real home ownership is only achieved when the debt is retired, and the shortest route to success is to pay off a mortgage early.
Pay off mortgage debt early? Am I crazy? Why would anyone do that in an era of 4% debt? Because true ownership is a claim to real estate without encumbering debt. Debt isn’t something to be endlessly serviced. It’s something to be used to a specific purpose, then retired as quickly as possible. Perhaps this idea isn’t fashionable, and someone is bound to argue it’s not “sophisticated” financial management, but it’s the best way to build wealth and secure a stress-free retirement.
In Home ownership with no mortgage is the best retirement plan, I noted, “… you can take the excess rent and put it toward the mortgage paying off the debt more quickly. Remember, the goal is to have maximum free cashflow in retirement, so you want to pay off those debts.” Retiring debt is part of the cashflow investment mindset; it is diametrically opposed to speculation. Retiring debt is the key to retiring from work. The faster you can accelerate the repayment of debt, the sooner your investments are paid off, and the sooner you can retire.
What I advocate is the opposite of HELOC abuse. Anyone who pays off a mortgage faster than a 30-year amortization schedule earns an “A” on my HELOC Abuse grading system.
Pay more when you can
There are two methods anyone can use to accelerate their home mortgage payments: (1) pay more when you get a raise and (2) make extra payments. One of the advantages of home ownership is that you have a stable house payment while renters face yearly increases. Why not take that raise and put some of the extra into your payment? If you get a 3% raise, you should be able to put 3% more toward your mortgage. If you do this, a 30-year amortization drops to 20 years.
Another method people use to pay down their mortgages is to make extra payments. If you are like the many people who are paid every two weeks, you get what seems like two extra paychecks a year. If you make one extra payment a year, you can pay off your mortgage five years early. If you can make two extra payments a year, you can pay it off almost eight years early.
If you combine both methods, you can pay off your mortgage in 16.5 years!
This plan does not require heroic efforts. You are putting the same percentage of your income toward housing, and you are spending part of two extra paychecks per year. It that too much to ask in order to pay off your debts early? Good financial planning can accelerate your retirement by many years. Do you want to work longer than you need to?
Refinancing for accelerated amortization
During The Great Housing Bubble, and even now, most people who refinance do not accelerate their amortization. If given the chance, most people will suck the equity out of their home and spend it. The more conservative ones will refinance into a lower payment and enjoy more spending money that way. What I am proposing is the most conservative alternative; take out no money, make the same payment, and pay off the debt quicker.
Time to Payoff
The Time-to-Payoff is the amount of time it takes to retire the debt used to acquire the asset (house). When people examine investments, they often look at rates of return to compare between asset classes. Rates of return are a valuable metric. When thinking about retirement finance, rates of return become less important than steady cashflow. We need a new measure of success for reaching your retirement goals: Time to Payoff.
Paying off debt is as difficult as dieting — there is always a temptation — whether it be spending or eating. The success rates for debt retirement are no better than they are for weight loss. Perhaps we should have a TV Show for the Biggest Saver. We need something to balance the shows about Housewives who compete for the biggest sense of entitlement.
Calculating Time-to-Payoff is a challenge. It requires looking at the available sources of cashflow and the impact the property has on its owner. There is a level of cashflow that can be diverted toward debt service that otherwise does not impact the owner’s life.
If the property is cashflow positive — which it must be for this analysis to work — there will be money that can be put toward debt service. If the maximum available cashflow is put toward debt service, how quickly does the loan amortize? That is Time to Payoff.
Have you heard of the financial planning concept known as snowballing? It’s popular among real estate investors who want to retire the debt service in preparation for retirement. Snowballing is taking the positive cashflow from one or more properties and using it to pay down the mortgage with the highest interest rate. Once that is paid off, it frees up even more cashflow to pay off the next mortgage. Like a snowball growing as it rolls down hill, the increasing cashflow grows larger and larger until the final mortgage is retired.
If you invest in the Time-to-Payoff way, your property investments will have no impact on your financial life — plus or minus — until you retire. There is no demand on your income to service the investment, and there is no net benefit for you to spend on your lifestyle. It’s the right choice to make for you and your family.