Hi Nick
I just came in to a lump sum and was thinking about paying down my mortgage. Do you think this is a good idea?
Marsha
Hi Marsha
Congratulations on your windfall! As you know I am a big advocate of being debt-free and your lump sum might be the opportunity to get you there faster. Paying down your mortgage will not completely eliminate your debt.
Most debts operate on an amortised basis, which means that based on the annual percentage rate (APR) and the balance, interest accrues on a daily basis between payments. Once you make your next payment the interest must be repaid first – this figure changes every month as your balance reduces – and the difference goes towards your principal. In the table and graph below you can see a lump sum being paid in April and a sharp drop in interest in May.
You will also need to check the provisions in your loan contract regarding lump sum payments and if any penalties are applicable. Even if there are penalties it may still be a good idea to pay the lump sum as in the long run you will pay less interest – so do not be deterred by a penalty.
Other Debts & Investments
If you have other debts that carry higher interest rates then consider these before making the mortgage payment, as your mortgage may actually be the lowest cost debt you owe. An opportunity may arise which could yield a far greater return than the interest cost on your mortgage. However, I strongly recommend that you do your due diligence before making any investment, as higher potential returns are often accompanied by a higher risk of loss. If you are already in business, say buying and selling of a product, then the profit may justify putting the money in the business rather than paying down the mortgage.
Need for Cash
Many people rush to direct the lump sum towards the house loan but be sure that you have enough cash on hand to deal with the unexpected (emergencies) – if you don’t you may be forced to borrow and usually at a higher cost.
If part of your plan is to acquire a second property or modify your current house to create rental income, then you may want to consider this cash as part of the capital for that project because, again, if you are short on cash you may have to face a lender all over again.
If you are on a fixed paycheque, making a lump sum payment on your mortgage is not a bad idea. However, if you are self-employed and are faced with fluctuating income you may want to consider holding back part or even all of this money to give you a cushion in months when income takes a dip.
Smaller Payments
Depending on the quantum of the lump sum you may be able to significantly reduce your loan balance and then approach your lender to reduce your monthly payments to improve the cash flow. The only challenge with this is that the debt will not be repaid as quickly as if you had just simply continued paying your original installment.
If you have any further questions or need advice on today’s subject please email me at: NickAdvice@gmail.com or web me at: www.FinancialCoachingCentre.com