In a previous post, I mentioned that I had recently become debt free outside of the mortgages on my primary residence and investment condo. In that blog post, I announced an outrageous goal of paying off the mortgage on my primary residence in 7.5 years. I gave you the cliff notes version of the strategy I devised to accomplish this big, hairy, and audacious goal. And in this post, I want to expand upon the thinking and get more granular on the strategy. My hope is that by the end of this post you will realize that this strategy is easy and anyone can follow it, but most won’t. Only those that are truly in pursuit of financial independence will have the discipline and willpower to follow through on this strategy.
To the Victor go the spoils. – Unknown
First I would like to point out that this is a plan that involves absolutely no austerity to your current lifestyle. I got the idea from a retirement savings strategy referred to as the “save more tomorrow plan.” The premise is that you start with the minimum contribution to your 401K that your company matches, which is typically in the 3-6% range. The goal is to increase the contribution as a percentage of your income in order to max out your 401K (which maxes out at $18,000 as of 2015). However, the objective is never to feel any pain during this increase process. So you only increase your contributions every time you get a raise. This ensures that you never get used to the increase in income and helps work towards eventually maxing out your 401K. Thus the “no pain” comment.
I have a different philosophy on maxing out your 401K. In my opinion, it is imperative that you max it out as soon as possible, and ideally, that should be during your first year in the workplace. If you think about it, you are typically just getting out of college and are now making more money than you ever have. Even if you maxed out $18,000 on a $50,000/year salary, I would wager that you are likely still making multiples of what you made while you were going to school. Now I will be the first to admit that I am probably a bit biased since this is the path I chose when I first entered the workforce. I have been maxing out my 401K since day 1.
Nonetheless, I do like the underlying philosophy of the strategy and its application to paying down debt and particularly a mortgage. So let’s dive in and get under the hood of this strategy…
If you have ever heard of “Snowball Momentum” then you will immediately understand why I chose the name I did. The basic concept is that if you start with a small snowball and roll it down a hill, you will gradually get a snowball that increases in both size and speed. You will see this effect as I layout the fundamentals of this strategy and see the exponential power come to life.
Let’s define the fundamentals of this strategy. If you can stick to the framework I have developed, it will make it much easier to adhere to and will increase your probability of success.
- Buy a house that is less than you can afford. You see most people get pre-approved for a loan during the house buying process. During that process, they find out the maximum loan they can obtain in purchasing a home. In my case, my wife and I were pre-approved to obtain a loan of up to $750K. We had no intention of ever buying a house that would require a loan that large. This is not true when it comes to how most people proceed. Most people go out and buy as much house as they can based on the amount of money they can borrow. My rule of thumb is to borrow around 2X your annual gross pay (and at most 3X).
- Increase your income every year. Ideally, you will increase your income by about 2.8-3% of your starting mortgage every year. So in my case with a mortgage of $350K, that calculates to about $10,000/year. Over 7 years that is an additional $280K (3% x $350K x 28 = $280K). In the table below you will see that by year seven you are making an additional $70,000/year based on the example.
Update 3/8/15: The table above is slightly off by $10,160, because this plan is seven years and three months. I am adding this in case you view my other posts where I expand on this strategy, so you don’t get confused.
- Practice the “Pay More Tomorrow” strategy. Like in the “Save More Tomorrow” plan, we only pay more to the mortgage in the form of additional principal payments when we get raises. Now every time you get a raise you will divide that gross amount by 12 and increase your mortgages principle payment by that amount. So again based on my real life example, in year 1 I would take the $10,000 increase in income and divide it by 12, resulting in $833/month. Anything above the $10,000/year increase I am free to do what I wish with. Or I could be more aggressive and pay the mortgage down even further, thus getting it paid off faster.
That’s it. There are only three underlying fundamentals to make this strategy work. Now let’s take a look at the details over the next seven years based on my real life example…
What paying my mortgage off in 7 years looks like
In the above chart, you can visually witness the true snowball momentum or exponential effect of this strategy. Also, I will point out that the equity curve is based on the current market value of $383K per Zillow. We purchased the house for $370K and have an outstanding loan of $350K.
Below is the detailed data table with all the relevant data points by month, with each year representing a milestone.
Remember from my previous post, it was going to cost us $230k in interest over the life of the loan (if held for the full 30-year term, and it assumes no rise in interest rate, but we have a 5/5 arm which could see the interest rate increase). Now a good point to make is that if our rate was to go up the maximum 5%, as fast as allowed by the terms of the loan, this would result in an additional $215K in interest savings (by paying it off in 7 years that is). So all savings calculations were done very conservatively.
Now with this conservative example, we are only paying $62K in interest. YES, that is a $170K savings based on the conservative/base case.
And the awesome part is that we will be mortgage free before we are 35 years old. This is when many of our peers are either just buying their first house or are still in the first decade of their 30-year loan. Just think, more and more of our generation are living with their parents longer, thus delaying the home buying process.
This plan is very easy to do. But it’s also very easy not to do. But imagine the options it gives you if you just have a little discipline.
Let me be honest. My real goal is to pay it off in 5 years, but that is my stretch goal and it may be a bit aggressive (but worth trying).
Here are the numbers that made me realize that there is no reason why this wasn’t feasible. Over the next seven years, this strategy will only account for about 22.3% of the cumulative gross income we will earn (see table below). The numbers don’t lie. How can I not do this? 22.3% is not that much in the grand scheme of things. And look, over five years it is still only 32.6% of cumulative gross income. I have seen many people who pay up to 50% of their gross income just to amortize their regular mortgage over 30 years.
So what do you think? Are you ready to put a plan in place to pay your mortgage off early? Can you imagining what life would be like with no mortgage? Let me know what you think in the comment section below.
– Gen Y Finance Guy
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