You may wonder what I’m referring to. Well it’s actually a simple one that many people in many countries do naturally but that, for whatever reason, is very undeveloped in the US.
It’s the early mortgage repayment.
Think about it. Let’s imagine that you have a mortgage with a 5.5% interest rate and that your income puts you into the 28% tax bracket (marginal). Now do the math.
If you want to $100 the real calculation and reasoning can start as follow: What is the risk free investment I can find that can guarantee me a 5.5%/(1-28%) = 7.64% gross return?
When you reimburse your mortgage in advance, thereby reducing your total payment years (but not monthly payment), you are virtually making a 7.64% risk free investment (under the above assumptions). You will never pay interest on it so you are not making 7.64% gross but your are saving 5.5% net. What’s left in your pocket it the same result.
Another way to look at this is to think in term of cash flow over the years. Let’s assume you have a mortgage that will run for another 10 years for it’s 50k capital to reimburse, still at 5.5%, and that you have an extra $100 to spare. You have 2 (savings) options: reimburse the mortgage or invest it.
A future post will share the actual calculation taking into account the time value of money and under various assumptions.