If you find yourself with extra money from a salary increase, bonus or unexpected windfall, you may be considering paying off your mortgage early.
Paying off your mortgage before the end of the agreed-upon loan term can save you money on interest and open up considerable space in your budget.
Moreover, owning your home outright will allow you to tap into that equity in the future and provide you peace of mind.
Read on to learn more about the pros and cons of paying your mortgage off early and how it can benefit your personal finances.
Table of contents
- Should you pay off your mortgage?
- How to pay off your mortgage early
- Other considerations
- Alternatives to paying your mortgage off early
- Summary of Should You Pay Off Your Mortgage Early
Should you pay off your mortgage early?
Depending on the size of your home loan, you could potentially save thousands of dollars in interest by paying off your mortgage early. Should you decide to do this, it's advisable that you keep cash reserves to cover other day-to-day expenses and potential emergency repairs.
Based on calculations using our mortgage payment calculator, if you had a 30-year, $300,000 mortgage with a 4% interest rate and put 20% down, your minimum monthly payment — not including property taxes — would be around $1,146.
In this scenario, you would pay $172,487 in interest over the life of the loan.
Say you increase your monthly payments to around $500. This would allow you to pay off your mortgage in 20 years instead of 30. In this case, you would pay a total of $109,045 in interest overall, saving $63,442. Plus, there’s the added benefit of getting out of debt a full decade earlier than anticipated. Of course, the results of this calculation will depend on your current mortgage balance.
The majority of fixed-rate loans are amortized. Amortization refers to the process by which you gradually pay off a loan. At first, the majority of your monthly mortgage payments go toward the interest, and anything left over goes toward the principal loan balance. As your balance decreases, monthly payments shift to primarily go toward the principal.
Pay off your mortgage early — Pros and cons
- No more monthly mortgage payments
- The property will belong to you 100%
- Extra cash flow
- Possible prepayment fees
- You'll no longer be eligible for mortgage interest tax deduction
- Your credit score can take a hit because you'll be closing an account
- A considerable amount of your liquidity will be tied up in your home
Should you pay off your mortgage or invest in the stock market?
Deciding whether to pay off your mortgage or invest comes down to mathematics and personal choice.
On the one hand, given the current low-interest rate environment, investing could be much more profitable than paying off a fixed-rate mortgage with a low rate. On the other, being debt-free could provide homeowners great peace of mind.
If you were to find an investment that could generate an after-tax rate of return (RoR) that is higher than your current mortgage rate, investing could be a better deal.
Going back to the example in the previous section, if you had a 30-year mortgage with a 4% interest rate and could pay an extra $500 each month, you could get out of your mortgage 10 years earlier and save around $63,442 overall. If you chose to invest those $500 in a stock market fund instead and continued investing the same amount each month for 20 years, assuming an annual return of 7% (compounded annually), your investment could be worth $247,908 at the end of that period.
While the numbers might make this decision seem like a no-brainer, the choice should come down to your personal financial situation, says Haley Tolitsky, CFP at Cooke Capital. "Remember, you actually need to invest the funds that you would be using to pay down your mortgage consistently, and the stock market can be volatile in the short-term, so make sure you are investing for the long-term and understand the risks of investing first," she adds.
Investments are not guaranteed, and the stock market could lose 40% of its value in a recession — a time during which job security is not guaranteed. The safest bet for many risk-averse homeowners could be to free up their cash flow by paying off their mortgage early.
Here are some of the pros and cons of investing:
- Having a potentially higher rate of return
- Greater liquidity and protection from inflation
- Investing through a taxable account (versus a 401k or IRA) allows you to easily sell your assets for cash if need be
- A return on your investment is not guaranteed
- The market can be volatile, causing your portfolio to lose value
- You may have to pay investing fees
Regardless of your choice, always have a financial cushion to fall back on. Experts advise against using all of your liquid assets to pay off a mortgage. Similarly, it would be wisest to have six months' worth of mortgage payments and other expenses set aside before investing in the stock market.
As with any big financial move, we would encourage you to first do the math using a compound interest calculator and to consult a financial advisor to see how this decision fits into your overall financial plan.
How to pay off your mortgage early
If you have made up your mind to pay your mortgage off early, there are several ways you can go about it.
Make additional monthly payments
Of course, paying off your mortgage ahead of time will entail making additional payments, either monthly, annually or as a lump sum.
Choose a biweekly payment schedule
Paying half of your mortgage payment every two weeks will result in one extra full payment at the end of the year. The math is simple: 26 half payments will total 13 full mortgage payments every year.
This additional payment, applied to the principal, will shorten the life of your mortgage in small increments. Double-check the terms of your agreement and make sure your lender doesn’t charge some sort of fee for setting up a biweekly payment schedule. Some lenders will allow you to automate biweekly payments, but you may need to manually pay your mortgage, which could result in accidentally missing a payment.
Pay extra each month
Another way to pay off your mortgage faster is by paying more than the required amount each month. Most lenders will allow you to automatically pay any amount you wish. So you can add just a few dollars or massively increase your payments, whatever works for your budget.
Some people even take out 30-year loans but commit to paying as though they took out a more expensive 15-year loan. This way, they can save time and interest but have the flexibility to pay less if needed.
Another strategy is to take the total amount that is due every month, divide it by 12, and add that extra amount each month. As with the biweekly payment schedule, this will result in one extra mortgage payment each year.
To be clear, there are no hard and fast rules when it comes to making additional payments on your home loan. Also, there is no limit on the number of extra payments you can make.
Make a lump-sum payment
A lump-sum payment is a one-time payment toward the principal balance of your loan. A lump-sum payment won't change your loan terms but will result in you paying less interest over the life of your mortgage and getting out of debt sooner.
Here are other factors to take into consideration when deciding whether to pay off your mortgage ahead of time.
A mortgage prepayment penalty is a fee that mortgage lenders charge if the homeowner pays off their loan ahead of time. The penalty is supposed to be a deterrent for borrowers, incentivizing them to continue making monthly payments that include interest payments to the lender.
There are federal laws in place that prohibit lenders from charging prepayment penalties on certain types of loans, such as FHA and USDA mortgages and student loans.
In cases where lenders can charge prepayment penalties, these are regulated. This means there are penalty caps (2%) and periods of time after which the prepayment fee cannot be charged. For example, some laws prohibit lenders from charging a prepayment penalty after three years. Ask if your lender charges a prepayment penalty and under what circumstances.
Principal vs. interest payments
The principal balance is what you borrowed from your lender to purchase your home. The monthly payments you make are split between principal and interest. Interest is the money you pay your lender for giving you the loan. Your monthly payments also cover insurance, taxes and sometimes other fees.
By making direct payments to your principal mortgage balance, you’ll pay off your mortgage loan quicker, build home equity faster and save money on interest. If your goal is to pay off your mortgage early, make sure your extra payments are going toward principal.
Alternatives to paying your mortgage off early
Consider mortgage refinance
Currently, mortgage rates are around the 3% mark, and experts predict that they will rise in 2022 but remain relatively low. Refinancing your home loan and locking in a lower mortgage interest rate with one of the best mortgage refinance companies can save you money each month. Alternatively, you can opt for a shorter term that will save you time and potentially thousands of dollars in the long run.
That said, the best time to refinance is when you can lower your interest rate by at least 0.75 percentage points. At current mortgage rates, this is possible for millions of people. However, keep in mind that a refinance does include closing costs.
Also, watch out for any potential scams and double-check offers that sound too good to be true. Again, if need be, consult with a professional.
Use a mortgage refinance calculator to determine if refinancing is the right move for you.
Look into mortgage recasting
A mortgage recast is when a lender recalculates a new loan balance and puts forth a new payment schedule, usually after the borrower makes a large payment toward the loan’s principal balance.
This new payment or amortization schedule will detail principal and interest percentages in each payment due from that point until the loan is scheduled to be paid off.
Since the new loan balance is naturally lower, a mortgage recast results in lower monthly payments for the borrower.
That all depends on your financial goals. But if you're looking to save money, then an early mortgage repayment can be a smart move. Not having to pay interest for even one year will make a considerable difference. That said, your lender may charge you a prepayment penalty.
These aren't necessarily dealbreakers, but do your research and consult a financial planner to determine if paying your mortgage off early is the best move for you.
Summary of Should You Pay Off Your Mortgage Early
- Paying off your mortgage early will save you money on interest.
- Depending on your agreement, your lender may charge you a prepayment penalty.
- Just adding one extra monthly payment each year will help you pay off your loan faster.
- Paying off your mortgage early can slightly affect your credit because it will represent a closed account.
- Using a mortgage calculator, or a mortgage payoff calculator can help you crunch the numbers and determine the best course of action for you.