June 3rd, 2009

By Andre Plessis
The Danger of Paying Off Your Mortgage Early

Before you decide to pay off your mortgage balance faster with extra principal payments every month, you should analyze and see if it is the best strategy.

The biggest risk in lending for banks is that you stop paying your mortgage, because you suddenly lose your employment, you divorce, you get into an accident etc.  In that event, the lenders hope that you owe them as little as possible against the value of the home. 

That way, your mortgage balance is covered in full and paid off in a discounted sale via foreclosure. If you fail to make your mortgage payment, the bank will be in a much better position if you have a low loan to value ratio. If you owe $100,000 on your mortgage and the home is worth $500,000, then all they have to do is sell it for the amount of the mortgage you owe, plus all the fees the foreclosure incurred to the bank and they will be fine.

The biggest loser will be the homeowner, who will most likely lose all the home equity, in this case $400,000 in home equity. When there isn't much equity, the lender carries all the risk. When there is a lot of equity in the home, risk risk is transferred to the borrower who may risk to lose everything if he is not prepared against unfortunate life events.

The fear of foreclosure is why lenders are eager to take your extra dollars and to help you increase your equity position through bi-weekly payments and other systems. 

When banks encourage you to pay down your principal balance, their hope is that you will voluntarily decrease their stake they have.

Important to remember, though: your interest rate is determined by the risk that you represent to the bank.  When you pay down your mortgage balance with extra principal payments, your risk to the bank decreases. 

However, do you think that the bank will call you to offer you better interest rates when their risk is lower?

Therefore, before paying extra principal every month, consider some of your alternatives to cover yourself: 

Once you give the money to the bank, you can only get it back if you refinance under the lender's condition, or if you sell your home. Another important point is that when you give the extra money to the bank you are basically telling: "Mr. Banker, please take my money and do not pay me interest on it." This is just food for thought.