Analyzing different mortgage payoff strategies
So you got a new home and along with all the excitement and joy that comes with a new home, came a 25 yr long mortgage. In this post, we will analyze different strategies to payoff a mortgage. We will explore how compound interest interplays with different payment cadences, one-time payments, etc.
Disclaimer: I am not a financial advisor and this blog post is for educational purposes only.
Before we dive into the different strategies, let’s set some baselines. Let’s say
- We have a loan amount of $520,000.
- Our annual interest rate is 3.14%.
- Our term length is 25 years or 300 months.
- We have a fixed rate till 5 years and then it changes to a variable rate.
- Our variable interest rate minimum is 3.38% (following Bank of Canada prime rate for today and median of standard deduction by the big 3 banks).
- Our variable interest rate cap is 5%. Historically Bank of Canada has gone up to about 4%. We take 5% for our calculations.
- Interest rate adjustments are done every 12 months.
- Interest rate adjustments are 0.25% (approximately follows Bank of Canada rate adjustments).
- The mortgate is compounded semi-annually. This is true for all Canadian mortgages.
Alright, now that we have the baselines established, let’s move on to the strategies.
Strategy #1: monthly payments for 300 months
The most common way to pay off a mortgage - we pay off a portion of the interest and principal, every month, for the next 300 months. We get a pretty standard amortization plot and payment schedule.
The red cells represent when we are paying more interest than principal. If we pay a fixed amount every month, we will start paying off more principal than interest from the 35th month of the mortgage. Our mortgage payment per month would be $2,498.38 and we would have saved $0 in interest.
Strategy #2: accelerated bi-weekly payments
Accelerated bi-weekly is, as the name suggests, paying every 2 weeks instead of every month. Which means we will be paying an extra week every year. Let’s see how our amortization table looks with that.
As we can see, we will start paying off more principal than interest right off the bat. Also we will be paying off our mortgage in approximately 23 years and our mortgate payment every 2 weeks would be $1,249.19 and we would have saved $35,298.57 in interest. Assuming we get paid monthly, a bi-weekly payment schedule would cost us $2,498.38, the exact same amount as a monthly mortgage except the 1 extra week per year.
Strategy #3: accelerated weekly payments
Similar to strategy #2 but every week instead of every 2 weeks.
Again we gain equity right off the bat. Also we will be paying off our mortgate in approximately 22.7 years and our mortgage payment every week would be $672.60 and we would have saved $39,194.03 in interest. On a monthly cadence, we would have paid $2,690.40 per month with 2 extra weeks per year.
Those are the 3 most straight forward strategies. Now let’s say we choose strategy 2 because we pay only slightly more per year than strategy #1, how can we further reduce the interest paid over the lifetime of the mortgage?
Strategy #4: Making an extra annual payment with accelerated bi-weekly payments
Now let’s say we save up and make an extra payment every year. Most banks would allow up to 10% of extra payments, so let’s factor that in. For a mortgage of $520,000 though, that’s a whooping $52,000. Let’s say we don’t have that money. So we drop it to 1%, or $5,200 and repeat for the term of the loan. That would save us $42,025.57 in interest. $5,200 per year is about $433 per month or $216.50 every 2 weeks approximately.
So combining this with strategy #2, by paying $2,938.31 every month, we would save $42,025.57 in interest.
Strategy #5: Payment increase with accelerated bi-weekly payments
Let’s say we want to increase our bi-weekly payments every year by a small percentage. That percentage could depend on increase in income, inflation and new expenses. Let’s say we want to increase our payments by 10% or $124.92 and repeat for 24 years. That would save us $82,169.84 in interest over the term of the loan. I say term of the loan because the term then, would be reduced by about 10 years and 9 months.
Strategy #6: Extra annual payment with payment increase with accelerated bi-weekly payments
With the 3 strategies combined (3, 4 and 5), we would save $94,176.73 in interest with the following schedule:
- We would make 10 payments of $5,200.00 each, every year for 10 years, amounting to $52,000.
- We would have 10 increases of $124.92 each, every year for 10 years.
We are saying 10 years because we will be done with our mortgate payments by the end of the 11th year. Here’s the payment schedule:
All of the strategies above, for simplicity’s sake, does not do a comparitive analysis of investing the extra money in a fund with a growth of, let’s say, 7% compounded annually. For instance, instead of paying $5,200 extra annually, we could invest that in a fund that pays a 7% dividend. At that compound interest, at the end of 10 years, that fund would grow to $82,074.72.
Then you would have to decide whether it’s worth paying off the mortgage or investing the surplus in a fund. But that’s fodder for a subsequent post.
I am a Software Development Engineer at Amazon Canada and love working on complex distributed systems, both organic and algorithmic. More recently I have taken an interest in React and front-end development. In my free time, I like to take photos, spend time with my family and travel.
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