Paying off a mortgage is a significant milestone for many homeowners, and the opportunity to make a lump sum payment towards your mortgage can be both exciting and daunting. Whether you have come into an inheritance, received a bonus, or saved diligently, deciding whether to put a large sum of money towards your mortgage is a decision that requires careful consideration. Let’s explore the pros and cons of making a lump sum payment on your home mortgage to help you make an informed decision.
Pros of Making a Lump Sum Payment on Mortgage
1. Reduced Interest Payments
One of the most compelling reasons to make a lump sum payment is the potential interest savings. By reducing the principal balance, you will pay less interest over the life of the loan. This can lead to substantial savings, especially if you make the payment early in the loan term.
2. Faster Loan Payoff
A significant reduction in the principal balance can shorten the time it takes to pay off your mortgage. This means you could become debt-free sooner and own your home outright.
3. Increased Equity
Making a lump sum payment increases your equity in the home. This can be particularly beneficial if you’re considering a home equity loan or line of credit in the future.
4. Peace of Mind
For some, the psychological benefit of reducing debt and moving closer to owning their home outright is a powerful motivator.
Cons of Making a Lump Sum Payment on Mortgage
1. Opportunity Cost
The money you use to pay down your mortgage could potentially be invested elsewhere. If you can earn a higher return on your investment than the interest rate on your mortgage, you might be better off investing the money instead.
2. Liquidity
Once the money is tied up in your home, it is not as liquid as cash in the bank or investments that can be easily sold. This could leave you vulnerable if you encounter unexpected expenses or investment opportunities.
3. Prepayment Penalties
Some mortgages have prepayment penalties that could make paying off your mortgage early more expensive than anticipated. Be sure to check your mortgage terms before making a lump sum payment.
4. Emergency Fund
It is crucial to have an emergency fund in place before considering a lump sum payment on your mortgage. Using all your savings to pay down your mortgage could leave you financially vulnerable.
Making the Decision
The decision to make a lump sum payment on your mortgage should be based on your individual financial situation, goals, and risk tolerance. Here are a few steps to help you decide:
1. Assess Your Financial Health
Ensure you have an emergency fund and that you are on track with other financial goals, such as retirement savings and education funds.
2. Consider Your Mortgage Terms
Look at the interest rate, remaining term, and any prepayment penalties.
3. Evaluate Investment Opportunities
Compare the potential return on investment with the interest rate on your mortgage.
4. Consult a Financial Advisor
A professional can provide personalised advice based on your financial situation and goals.
5. Plan for the Future
Consider how paying off your mortgage fits into your long-term financial plan.
An Example of Lump Sum Payment on Mortgage
Let’s use an example to illustrate. Assume that the loan is RM 300,000 with tenure of 30 years and an interest rate of 4% per annum. The monthly installment is RM 1,432.25. After paying for 5 years, the loan balance is now RM 271,342.54. The interest left after paying the loan for 5 years is RM 159,237.46. If I have RM 50,000 and put it towards the mortgage, what will be the interest savings?
If I pay RM 50,000, the loan tenure will reduce to 217.5 months, roughly around 18 years, with the original instalment. It is a reduction of 7 years. The total interest paid will be around RM 90,215.71. Thus, the total cash outlay will be RM 140,215.71.
By subtracting the figure from the original interest, we will have a saving of RM 19,021.75. Thus, the outcome of a lump sum payment of RM 50,000 is a reduction of 7 years in the tenure and a reduction in interest payable of RM 19,021.75. Overall, it looks good so far.
Nonetheless, the RM 50,000 can be used for investing too, rather than used as a lump sum payment on mortgage. Let’s say I invest the lump sum in Employees’ Provident Fund (EPF). I assume its return is 5% per annum. The money will be left in EPF for 18 years which is the payment tenure after paying the lump sum to mortgage.
RM 50,000 compounding at a rate of 5% for 18 years will become RM120,330.96. Deducting the principal, I will have a profit of RM 70,300.96. It is 3.7 times more than the savings I get by putting the lump sum towards my mortgage! This is the opportunity cost of making lump sum payment on mortgage.
To Do or Not To Do?
So, should you make a lump sum payment on your mortgage? The answer depends on you. If you want to be debt-free as soon as possible, making a lump sum payment will help you pay off the mortgage sooner, thus achieving your goal earlier. On the other hand, if you want to maximise the value of your money, perhaps this is not the best move.
In conclusion, while making a lump sum payment on your mortgage can offer significant benefits, it is not the right choice for everyone. Careful consideration of your financial situation and goals is essential to making the best decision for your personal circumstances.
How can a financial planner help you?
I can help you to determine your savings from making the lump sum payment on your mortgage. Based on your financial goals and objectives, we will also discuss on the pros and cons of making the lump sum payment on your mortgage. Besides that, we could also explore other uses of your money.
If you wish, I can also develop a plan to reach your goals and objectives. This normally involves saving and investing. Furthermore, I will also help with your tax planning to reduce your tax liability. Depending on your situation, we may also work together in other areas of your finances, such as estate planning.
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Disclaimer: This post is for informational purpose only. You should use judgment and conduct due diligence before taking any action or implementing any plan suggested or recommended in this article.
