Changing Our Mortgage Payoff Strategy

Ever since we bought our first house in 2003, we’ve always paid extra on our mortgage.  Even in the early days of being self employed when we had barely any money, we always tried to put at least a little extra money towards the mortgage principal each month – even if it was only ten dollars.  When we bought our current house, we opted for a 15 year mortgage, and set a goal of paying it off in seven years.  So far, so good.  We’ve been here 2.5 years and have paid off a little more than five years on the loan.  Our current amortization table shows the house being paid off 9.75 years from now if we stop making additional payments and just pay the monthly bill as scheduled.

Our strategy with paying off the mortgage has always been pretty straightforward.  We just add whatever we can each month to the payment we make to our loan company, with instructions to apply the additional money to the principal balance.  That has always worked well, and in the last 2.5 years, it’s put us 33 months ahead on our mortgage.  Seeing the house become more and more ours instead of the bank’s definitely makes all of our frugal habits worth the effort.

But we’re changing our strategy a bit.  The goal is still to pay off the house within the next four or five years.  But instead of sending the extra payments directly to the mortgage company each month, we’re putting them into a municipal bond fund at Vanguard instead.  We’ve had the fund for nearly two years, and have always considered it an emergency fund.  Knock on wood, we’ve never needed to take any money out of it.  Starting this month, we increased our monthly automatic contribution to that fund to be roughly equal to what we had been paying in additional mortgage principal.  And we’ve scheduled our mortgage payment to be just the regular amount due with no additional principal payment.

Once the balance in the bond fund equals the outstanding balance on the mortgage, we can pay off the loan in one lump sum.  We’ll probably actually wait until we have a bit more in the bond fund, in order to still have an emergency fund in place when we pay off the loan.  But you get the idea.

The interest rate on our loan is 4.625% (and we take the standard deduction on our taxes, so we don’t get a tax break for our mortgage interest).  The bond fund is currently paying roughly 3.5% in dividends and had been very consistent over the two years we’ve had it (the money we earn in the account is exempt from federal taxes since it’s a municipal bond fund.  We do pay state taxes on most of it – except for the bonds that are issued in our state – but that doesn’t amount to much).  The one drawback to the bond fund is that it’s not FDIC insured, but we’re ok with that.  It’s diversified across municipalities all over the country, and we feel very comfortable with it.  As far as we’re concerned, the 1% difference in rates between the mortgage and the bond fund is more than justified by the fact that if we put the money into the bond fund, we can still access it in an emergency, even though it’s earmarked for paying off the mortgage.  Whereas if we just send it straight to the mortgage company, it can’t be used for anything else.

If everything continues to go great, there will be no (or very little) change in the eventual outcome.  We’ll pay slightly more in interest on our mortgage over the next few years, since the principal balance won’t be dropping as fast as it was when we were paying additional money each month.  But the dividends we’re earning in our bond fund will increase faster than they were in the past.  And a few years down the road, we’ll be able to just pay off the mortgage in one big chunk.

But what if everything doesn’t continue to go great?  What if our income drops significantly?  What if one of us gets sick or disabled? (we do have disability insurance and an HSA, but a little extra cushion can’t hurt).  We’ve been in the health insurance industry for nearly a decade, but there’s really no way to know what the industry will look like five years from now, between reform laws, elections, court decisions, etc.

Those what-if scenarios were the deciding factor for us.  We’ve proven to ourselves that we’re very disciplined when it comes to money.  The contributions to the bond fund are already set up to be automatically drafted each month, we we know we’re never going to just pull the money out to go on vacation or buy a boat.  We’ll still consider it off-limits, just as it would actually be if we had sent it to the mortgage company each month.  But if we were to truly end up between a rock and a hard place, we would be able to use the money for something else.  Like making mortgage payments each month if we were to be without an income, for example.

We’ll see how it goes.  Here’s hoping we don’t run into any of our what-if scenarios, and the balance in the bond fund eventually meets up with the principal balance on the mortgage.  But it will also be a good feeling to know that we’re better prepared to take on financial challenges if they were to happen.

If you’re paying off your mortgage faster than scheduled, are you doing it directly through the mortgage company, or are you stashing the extra payments in another account and waiting until you can make a lump sum payoff someday?