For nearly two decades now, I have seen too many homeowners paying extra toward their mortgage without first having sufficient cash in the bank to weather unforeseen financial problems or while carrying other high-interest consumer debt. The hard truth for many is this: most homeowners should be using their extra money for other purposes before sending in those additional dollars to pay down their mortgage balance.
If you are wondering whether or not it makes good financial sense for YOU and your family to pay extra on your monthly mortgage payment, here is an extremely helpful formula I have taught to thousands of homeowners over the years of consulting and advising. Whether you have $50, $500, or $5,000 left over at the end of your month, here are the “buckets” to put your money in, and the order in which to do so that we teach:
#1 – Establish Cash Reserves: Set a goal for how much you and your family need for all of the “what ifs” that come along. This isn’t a new idea, but unfortunately just about every financial study done shows that most people couldn’t last 2 months without their income. I call this your “sleep well at night” money. Whether it’s a fixed amount, like $10,000, or a specific number of months of expenses, set the goal and start filling this bucket before your extra money goes anywhere else.
#2 – Eliminate Consumer Debt: Once you have achieved your Cash Reserves goal, start attacking any and all non-mortgage debt you have. Pay off those auto loans, credit cards, and even student loans. I don’t care how low the interest rate is. The problem is the monthly payments. It’s your hard-earned take-home pay going to pay for things that don’t build your future.
#3 – Build Savings and Liquidity: With your “sleep well at night” bucket filled, and your consumer debt paid off, it is now time to build your net worth. Most people, if they are somewhat fortunate, have money saved in retirement (Long-term, illiquid savings) and some in Cash Reserves (only for emergencies). You must begin filling up all those in-between buckets, such as college for the kids, cash for next year’s vacations, and money invested with a trusted financial planner that gives you flexibility down the road for possible career changes, loss of jobs, or larger unexpected financial problems.
#4 – Pay Off House: Your goal should absolutely be to someday own a house with no mortgage, and especially no mortgage payment. But too often I see homeowners jumping to this step before the first three, mostly due to poor advice or emotional reasons. Make sure this goal applies to your FINAL house. Is the house you are currently living in the same house you imagine being retired in and enjoying no mortgage payments in? If not, you may want to consider continuing to fill up the first three “buckets”.