Life has a habit of throwing us curveballs every now and then. There is no way of predicting when disaster will strike but it is possible to reduce the impact of an emergency by preparing a financial first aid kit that will help cushion the blow.
Obviously not all problems are made equal. It’s one thing to talk about having an emergency fund to cover unexpected costs such as the washing machine breaking down and quite another to plan for the possibility of losing your job and being unemployed for a few months until you find a new one.
If a real financial emergency strikes and you are unable to earn money for an extended period of time or have incurred a totally unplanned and extraordinary expense, then it is vital that you are able to reduce your monthly cash outlay as soon as possible. There are areas where you can cut costs quite easily, such as eating out or buying new clothes, but tackling issues such as monthly mortgage payments is much harder. This is a crucial thing to think about because mortgage payments usually take up a significant portion of our pay cheques (25% on average) so if our income dries up, paying the debt becomes a problem.
A few years ago my husband was looking into taking a year off work to get involved in an unpaid research project. This meant that we would have gone from two pay cheques to one, which would have been a severe hit from an income point of view. Our major monthly expense at the time was our home loan, so I contacted the bank to find out whether they would consider reducing our monthly payments for a year and I was absolutely astounded when they replied that they had no problem giving us a full moratorium for a year because we had made sufficient advances to cover one year’s worth of principal and interest payments.
Over the years I had often channelled any excess cash we had in the bank towards the loan, making extra payments whenever possible. The main reason I did that was to save on interest and it never occurred to me that the result would be a very important tool in my arsenal against financial problems. I did not actually set out to build a mortgage payment buffer, but build it I did and it came in very useful when we needed to reduce our outgoings for a period of time.
When you make extra payments on a mortgage you do not only reduce the principal due by the total of the advance payment, but you keep reaping benefits year after year because of the interest saved each year on the prepaid amount. This is the power of compound interest.
In the table you will see a rather simplistic example of the impact of a $1000 additional payment made in Year 1 for a loan with a 3.5% interest charge. The capital is reduced by $1000 in the first year, but the impact continues year after year because as the normal monthly payments are made, more money goes towards principal reduction as opposed to interest. By year 2 the total additional principal paid off is $1035 and in year 3 another $36.23 that would have gone towards interest is instead channelled towards principal. It goes one year on year and over a period of 10 years the original $1K prepayment results in a total reduction of the principal owed of $1410. In the case of a 25 or 30 year mortgage the impact over time becomes even more pronounced.
This means that when you make additional payments on your mortgage the impact of the extra money you put in grows over time and you could soon be in a position to ask your bank for a moratorium, giving you time to get back on your feet when adversity hits.
The following is a tangible example of how small additional monthly payments can buy you years off your mortgage, which can either mean that you pay off your loan in full years earlier than you had originally envisaged or that you have a payment buffer giving you the possibility to take “time off” from your monthly payments.
- Loan amount: $150,000
- Term: 30 years
- Interest: 3.5%
- Monthly payment: $673
- Additional payment: $67
Pete takes out a $150K mortgage but decides to pay $741 monthly instead of the required $673. As the prepayments and related interest hit the principal of the loan, a snowball effect kicks off that saves him $15,295 and shortens the time required to pay off the mortgage in full by 4 years 5 months. The graph below illustrates how the balance due decreases exponentially when prepayments are made.
10 years after buying his house Pete hits a rough patch. He is made redundant and has to start looking for a new job. He approaches his bank to explain his predicament and asks if he could stop his monthly payments until he finds a new job. His bank manager points out that he was supposed to have paid down the principal to $115,469 by this point but that he has actually already paid it down to $105,668. The discrepancy amounts to $9801, which is equivalent to Pete having made an extra 14.5 payments, so the bank has no problem to stop the monthly standing order until he finds a new job.
It takes Pete 6 months to find the perfect fit and he quickly gets back on track with his monthly payments, including the extra $67 monthly. Life goes on and 8 years later his daughter also encounters some financial difficulties and asks her parents for help. He visits his bank again and asks them to reduce his monthly payment. Once again they do not have a problem because he is way ahead of schedule. The monthly payment is reduced to the bare minimum required to cover interest and he gives the difference to his daughter every month. The additional payments he made over the years turned out to be a flexible and important part of his financial first aid kit and helped equip him for what life threw at him and his family.
My advice to anyone who has a mortgage is to decide on a sum that you can afford as an additional monthly contribution and set up a standing order for that amount to be automatically transferred out of your account each month. It does not need to be a large sum because over time the impact of even a small payment will grow and made a difference.
If you can afford topping up your monthly mortgage payment by 10% or more you will find that you will pay off your loan years in advance, while having the peace of mind that a payment buffer brings. That’s a great way of killing two financial birds with one stone.