“It seems like we will be making house payments forever. We owe $140,000 at 6% interest and are paying $1000 a month. How much sooner could we pay it off if we started paying an extra $100 a month?”
The above is a hypothetical question, but it could be you. There are two answers: the quick one and the dig deeper one. By clicking a few buttons on a financial calculator we discover the quick answer is 21 months; paying an extra $100 will reduce the payoff from 20 years to 18 years and 3 months.
Let’s dig deeper. Do you have other debt? Do you have any savings? Do you have an emergency fund? Are you on target with your retirement investments? Do you have children who will need some help with college funding?
Being as this is a hypothetical case, let’s say you are paying $300 a month at 12% APR on $5,000 on credit card debt and $500 a month on $8,000 on an 8% car loan. You have $2,000 in a savings account, nothing set aside for emergencies, you are on target with retirement investments and you have two children, ages 4 and 8. Your challenges are to not only get your house paid off, but also get out of debt, build an emergency fund and make plans for your children’s education. Don’t get overwhelmed. You can accomplish all of these and still pay your house off early by setting priorities and taking things one step at a time. Let’s develop a plan.
Clearly Communicated Budget
Yes, the dreaded “B” word…you knew it was coming. But until you are in control of your money, you simply cannot develop any type of a plan. It is essential that you and your spouse communicate openly while develop this budget. Discuss hubby’s dream bass boat and your dream kitchen. Leave nothing out now because it will surface later. Let’s assume you two worked together and decided that by eating out less, simplifying your vacations, getting a smaller tax refund and cutting back on Christmas spending, you find $500 a month positive cash flow.
Small Emergency Fund
Life happens, so you need a small emergency “buffer” fund. Simply label that savings account as an emergency fund and agree not to touch it for anything except emergencies. Voila! Your small emergency fund is complete.
Get Rid of Credit Card and Car Debt
We will come to paying your house off early in a minute, but let’s first free up more cash flow by attacking your credit card debt and car debt in that order. Keep making your regular car payment while bumping up your credit card payments to $800 a month (the $300 you were already paying plus the $500 you found in your budget). In seven months, when your credit card debt is gone, add the $800 you were paying on the credit card to the $500 you are paying on your car. With new payments of $1,300 a month on a car debt, which is now down to $4,800, it will be gone in about four more months. Are you still with me? You have just paid off your credit card debt and car loan in only eleven months. By doing so, you have increased your cash flow from $500 a month to $1,300 a month. Congratulations!
Time for a Big Emergency Fund
Grandma called it her “rainy day fund” for good reason: rainy days come. A big emergency fund is a higher priority than paying off your house early because when emergencies come, you need readily accessible funds. More equity in your house would not help if you lose your job tomorrow. Depending on your number of income streams and volatility of your job, you need at least three months of expenses; many financial planners recommend six months and some nine months. Let’s assume your expenses are $3500 a month and go for a six month emergency fund. Your goal therefore is $21,000, so you need to save $19,000 to add to the $2,000 you already have. At $1,300 a month, you will need at least 15 months to achieve this goal. After only 26 months, you have paid off $13,000 in debt and saved another $19,000. You are on fire!
You said that your retirement was on track, so I am taking you at your word. If it wasn’t, you should be investing enough of this $1,300 cash flow each month to bring your retirement investment level up to 15% of your take home pay.
Your two children are now 6 and 10. You could start making huge house payments now, but, because that added home equity cannot be easily converted to cash, college funding becomes a higher priority. For sake of discussion, you could achieve a $40,000 nest egg for each of them at age 18 if, assuming an 8% return, you start investing $300 a month for the oldest and $220 a month for the youngest. Check into a 529 plan to get some great tax breaks.
Finally! Pay the House Off Early!
You have been making $1,000 a month house payments all along, lowering your mortgage balance to about $132,000. Your monthly cash flow is now $780 a month ($1,300 a month less your college investments of $520 a month). If you decided to use all of the $780 to pay extra on your house, it would be paid off in only 7 years and 9 months, a total of 9 years and 11 months from the time you started your plan. At that time your payoff schedule was 20 years. You are awesome.
Our hypothetical family was able to pay off $13,000 in debt, save for a $21,000 emergency fund, plan for their kids’ college and pay their house off 10 years early. How did they do it? By creating a budget, making sacrifices, and developing a plan. I have a hunch that if you follow their lead, you would also see amazing results.