Get Financially Fit!

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I was talking with a friend the other day and he asked me if it was better to pay off the mortgage first or focus on retirement savings.  My personal preference is to save 15% toward retirement savings and then use incremental money to pay off your house.  My post titled, Create a financial plan, outlines my 10 recommended steps to retirement security.

If you have incremental money to put toward your mortgage here is a strategy to pay off your mortgage in half the remaining time of your loan.  In brief you create an amortization table and double up on principal payments.  The accelerated payment method that I’m describing worked for fixed loan mortgages. 

Step one of the process is to create an amortization schedule for your mortgage.  An amortization schedule details your principal and interest payment for each month.  I found a good amortization calculator at Bankrate.  Simply enter the loan amount, number of payment periods (in years or months, the interest rate, and the starting date of the loan.  The calculator will calculate both your monthly payment and the principal and interest payment for each month.  The Bankrate calculator also has the option of adding an incremental payment each month, adding an incremental payment each year, or adding a one time payment. 

To cut your mortgage payment time in half, simply send an incremental payment each month that matches the principal payment corresponding to the month that you are in.  Here’s an example:

Loan amount:  $200,000
Loan term:   30 years
Interest rate:  6%

The calculator determines that your monthly payment is $1199.10

In the first month, $199.10 goes to principal and $1000 goes toward interest.  In month 1 then send in an incremental $199.10 and your loan duration will shrink by an incremental 1 month. 

In the second month $200.10 goes to principal and $999.0 goes toward interest.  In month 2 send in an incremental $200.10 and your loan during will shrink by an incremental month (your loan will now end two months earlier). 

In an alternative scenario if you are 10 years into this same loan and want to begin this process, the incremental payment would be $341.20.  Simply print out the amortization schedule and begin paying the principal payment amount. 

The great thing about this recommended process is that you can send in incremental money and quickly determine the decrease in the loan term.  One way to apply this process is to print out the amortization schedule for your mortgage.  Whenever you send in an incremental principal payment for the current month then you cross off the last month on the schedule.  This has the benefit that you can visually see the the progress that you are making toward eliminating your mortgage.

One of my  motivations for writing this post is to warn you off of expensive software packages ($1000 to $5000) that supposedly help you pay off your mortgage faster.  You are much better off putting that money toward your mortgage payment. 

Follow your dreams, Achieve your goals! 

Help others!  Spread the challenge to Get Financially Fit!   

A small house can hold as much happiness as a big one.
         –Chinese Proverb

Purchasing and owning a home is a cornerstone of the American Dream.  This dream is poignantly captured by a recent quote that I heard from a woman,  “My dream is to own a small yellow house with a blue door; every other Sunday I will have my family and friends over for dinner.”  The fulfillment and benefits of owning a home can be significant. For example, when you own a home, you experience an increase quality of life from both having housing stability and having your own safe retreat from the stresses of life.  Buying and owning a home does have its risks and pitfalls though. For example, it’s important that you don’t overstretch yourself with too much house.

I recommend that you implement the following strategies to maximize your success with buying and owning a home:
1. Be patient and selective in your home choice.
2. Make a significant down payment.
3. Finance with a fixed mortgage.
4. Purchase a home appropriate for your income.
5. Build increasing equity in your house.

Let’s review these points one at a time.

Be patient and selective in your home choice.
Most people desire to minimize the frequency of buying and selling houses to minimize both transactions costs (real estate and mortgage fees) and the significant amount of work required to move. I recommend that you treat buying a house as a significant project. When making any significant purchase it’s best to clearly list out your requirements and preferences and take adequate time to make a wise purchase.

Clearly defining your purchasing musts and wants will prevent you from buying a house that doesn’t meet your needs. List out important factors such as the number of bedrooms, number of bathrooms, single or double story, proximity to your work place, size of garage, and of course price. Then define each factor as a must or a want. If you are married, I recommend that requirements and preferences are listed individually and collectively.

When you are in the process of buying a house, you will likely experience pressure from both real estate agents and mortgage brokers to proceed quickly. You may hear comments such as, “This house won’t last long at this price” or “You should move to lock in these interest rates.” This occurs when these people prioritize their interest of making money ahead of your interest of making the right purchase. I recommend that you ignore these pressures and take the time to be confident in your purchasing decision. When my wife and I purchased our house we took nine months to buy. By the time we purchased we knew exactly what we wanted and the fair market value of homes for sale.

Make a significant down payment
We are currently going through a national housing price correction that reminds us that putting no-money-down is a bad strategy. No-money-down mortgages are appealing because the enables people to get into a house, but can be painful when real estate values decline and people need to sell their house. I recommend that you make a 20% down payment on your house. At 20% you do not have to pay mortgage insurance (mortgage insurance is insurance paid by the borrower but provides protection for the lender). Of course, another advantage of paying 20% down is that your mortgage payment is lower. This is important because, many people underestimate increased expenses associated with owning a house. For example, you may need to pay for landscaping your yard, you may purchase furniture, and you may make home improvements.

Finance with a fixed mortgage
Traditionally most mortgages were sold with a fixed interest rate. This means that the interest rate charged (and thus the payment) was the same over the loan period. There has been a dramatic increase in the sale of adjustable rate mortgages. There are a wide variety of adjustable rate mortgage, but the most common ones have a period of time where the interest rate is fixed (five years for example), and then the interest rate changes annually based on the prime interest rate. If you are confident that you will be in a home for only five years, an adjustable rate mortgage may be appropriate. People are attracted to adjustable rate mortgages because the initial low interest rates enable them to purchase more house. The dilemma with adjustable rate mortgages is that if interest rates increase then your payments increase accordingly. Given that the majority of people don’t get a pay raise when interest rates increase, it’s more prudent to buy with a fixed interest rate. I recommend purchasing a house with a 15 or 30 year fixed mortgage. Be sure to compare the costs and rates of a mortgage from three different lenders.

Purchase a home appropriate for your income
Owning a home should bring fulfillment into your life; not increased stress. Banks and mortgage companies evaluate two ratios to determine your maximum mortgage. If you have no debt then the mortgage payment can be 28% of your gross income. The limit of your mortgage payment plus other consumer debts is 36%. For example, for a monthly income of $3000 the maximum mortgage would be $840 per month. If your income is $3000, you have an auto loan for $250, and a student loan for $200; then the maximum mortgage would be $630.

It’s important that you don’t take on too large of a mortgage. You will want to have incremental money for retirement savings, building up your rainy day fund, and sustaining a desirable quality of life. Before you purchase a home, mimic making a mortgage payment by saving the difference between your rent and the anticipated mortgage payment.

Build increasing equity in your house
In time, you will likely build equity in your house from the value of your house increasing, from improvements that you make, and from your mortgage principal decreasing in time. I recommend that you resist the temptation to take out home equity loans. I think that it’s a good idea to continuously improve your home over time. If you are energetic and skillful you may choose to make many improvements, if you hire professionals then you may initiate an occasional improvement. Home improvements provide an immediate increase in your quality of life. The long-term benefit of making improvements is that you should be able to sell your house easier if necessary. Home improvements typically don’t have full immediate payback, thus it’s best to limit the amount that is financed by a home equity loan.

Life Application
The next time that you purchase a home: slow down, enjoy the process, and make a great decision for your household. I recommend that you put down 20%, use a fixed interest rate mortgage, and limit your mortgage payment to 20% of your take home income. Once you own a home, continuously build equity by both avoiding equity loans and continuously improving and updating your home.

Follow your dreams, Achieve your goals!

I have received feedback from readers that, Get Financially Fit!, is the best personal finance book that they have read.  Specifically they indicated that they appreciated the practical steps as apposed to repeating a simple motivational  concept over and over.

I have just published the 2008 edition of Get Financially Fit!  This year I added two chapters - one chapter to eliminate debt and another one on retirement plans such as 401Ks / 403bs and IRAs.  The book has practical steps for assessing financial fitness, living within your means, short term investing, retirement planning, retirement investing, essentials of purchasing a home, and estate planning.

If you like this blog, you will find that this book helps you improve your personal finances so that you can follow your dreams and achieve your goals.

   Purchase the book from publisher >>