In theory, paying off your mortgage early can seem like a wise financial decision. You’ll save thousands of dollars in interest and eliminate at least one monthly expense. Doing so will also free up extra cash for other expenses or ventures.
However, in practice, paying your mortgage off early may not make the most financial sense for you. In some situations, the amount you save might not be more than what you would earn if those funds were put in various investment options. Depending on your current financial situation and goals, you may want to prioritize other things first.
If you want to join the nearly 40% of Americans who own their homes without the burden of a mortgage, you’ll need to consider a few factors to determine if paying off your mortgage early is the smartest decision.
Can You Pay Off Your Mortgage Early?
In short, yes, you can pay off your mortgage early. Although, If you consider going this route, you should contact your mortgage lender because you may be subject to a penalty for paying off your mortgage early.
Under the Dodd-Frank Act, mortgage lenders are generally prohibited from imposing prepayment penalties on home loans. However, the federal law was passed in 2014, and prepayment penalties do not retroactively apply to home loans originated before January 10, 2014.
If the terms of your mortgage allow for prepayment penalties, it can only be assessed during the first three years after the loan was consummated. The penalty is capped at 2% of the outstanding loan balance during the first two years. The penalty is dropped down to 1% of the outstanding loan balance for the final year.
For example, if your outstanding balance after two years is $250,000 and you decided to pay off your mortgage early, the lender could charge you a prepayment penalty of up to $5,000.
An Overview Of Paying Off Your Mortgage Early
One of the main advantages to paying off your mortgage early is the ability to potentially save hundreds of thousands of dollars in interest.
Let’s delve into it and see how it may look in practice.
When you make a mortgage payment, the bill is split between the principal balance, the amount you initially borrowed, and the interest. Due to amortization, most of your payments will go toward interest during the first few years. As you pay down the principal amount, you’ll owe less in interest. And as you start to approach the end of the loan, a large percentage of the payment goes toward the principal.
One tactic often used to expedite the process of paying down a mortgage is to apply extra payments directly to the principal balance. By making additional payments toward the principal, you’ll ultimately reduce the amount needed for interest before it can accrue. Thus, taking years off the loan and saving you potentially hundreds of thousands of dollars.
For example, you initially borrowed $165,000 to buy a home at a 4.5% interest rate with a 30-year term. By the time the loan is paid off, you would have paid a staggering $135,971.07 in interest. So, you would have paid $300,971.07 during the duration of the loan.
Now, let’s use the extra payment tactic using the example above. Let’s say you want to throw an additional $150 every month toward the minimum payment. By the end of the loan term, you would only have paid $95,157.62 in interest. That is a substantial decrease of $40,813.45. Additionally, you would have paid the loan off way earlier than if you kept paying the minimum payment.
Pros And Cons Of Paying Off Your Mortgage Early
There are some significant benefits to paying off a mortgage early, but it also comes with some negative consequences. Here are some of the pros and cons of paying off your mortgage early.
| Pros of Paying off Your Mortgage Early | Cons of Paying off Your Mortgage Early |
|---|---|
| Eliminates a large monthly expense—freeing the extra funds for investments to save for retirement | A good amount of your liquidity and net worth is tied up in your home, which might make it difficult to access later |
| The peace of mind knowing that the house is 100% yours | You will no longer be eligible for the federal mortgage interest tax deduction |
| An expected return rate that is equal to the interest rate on the balance you’re paying off | You end up missing out on potentially higher returns for other investments |
| The ability to tap the equity in your home if funds are needed in the future | Can significantly drop your credit score |
If you’re considering paying off your mortgage early, you’ll have to decide if the advantages outweigh the disadvantages.
Should You Pay Off Your Mortgage Early?
Paying off your mortgage early isn’t precisely as black and white as you may imagine. There are advantages and disadvantages to consider. Ultimately, you’ll have to analyze your current financial situation to arrive at the best decision for you.
Let’s discuss the situations where you may benefit from paying off your mortgage early versus when you don’t.
When paying off your mortgage early makes sense
It’s a common misconception that you need to pay an exorbitant amount of money per month to pay off your mortgage early. In actuality, a little extra per month can make a substantial difference throughout the duration of your loan.
We showed how adding an extra $150 per month can significantly affect the amount of interest you pay throughout the course of your loan. You don’t even need to add that much per month to notice a difference.
Let’s stay with the same hypothetical situation from above. Your mortgage is worth $165,000 at a 4.5% interest rate with a 30-year term. Contributing $50 per month will still save you more than $100,000 in interest, and you would pay off your mortgage years in advance.
If you have extra cash at the end of the month, consider adding a little extra to your monthly mortgage payment. You’ll notice a major difference as the years’ progress.
However, you shouldn’t toss extra money toward your monthly mortgage payment without careful consideration. Make sure you have enough liquid cash to cover any emergencies that may arise. A good rule of thumb is to have at least three to six months’ worth of expenses, so you aren’t in a pinch when an unexpected expense hits.
If you don’t have enough liquid funds to cover emergency expenses, you may want to focus on building up your emergency fund before contributing more toward your mortgage.
When paying the minimum monthly balance makes sense
Paying off your mortgage early may not be conducive to your financial situation if you’re still paying down other debts. That may include credit card debt, student loan debt, auto loan debt, and any other types of debt. Different types of loans generally come with higher interest rates than most mortgages. As a result, the interest will accrue at a faster rate than your mortgage will.
You should focus on tackling the other debt first before committing to paying off your mortgage early. You’ll save more money in the long run by focusing on your other debts first.
How To Pay Off Your Mortgage Early
Once you’ve carefully considered the pros and cons of paying off your mortgage early and you’ve come to the conclusion that it would be beneficial for you, use these tips quickly to become the sole owner of your home.
Move to a biweekly payment schedule
The simplest way to pay off your mortgage early is to switch from a monthly payment schedule to a bi-weekly schedule. For example, if your monthly mortgage payment is $900 and you switched to bi-weekly payments, you’d pay $450 every two weeks rather than $900 at the beginning or end of the month.
Since there are 52 weeks in a year, a bi-weekly payment schedule allows you to make an extra payment per year. As a result, you’d cut down your overall debt faster.
Play around with our bi-weekly mortgage calculator to see if switching to a bi-weekly payment schedule is right for you.
Make extra payments each year
As we discussed earlier, making additional payments can have a significant impact on your interest rate, and it will help you pay off your mortgage earlier.
You don’t have to make additional payments each month to see a difference. You’ll see the same effect if you make at least one sizable payment per year.
If you plan on receiving a tax refund, you may want to consider tossing some of that toward your mortgage payments. The average American received more than $2,800 during the 2021 tax season, according to the IRS.
Let’s say your mortgage is worth $165,000 at a 4.5% interest rate with a 30-year term. If you tossed an extra $2,000 per year, you’d cut off more than $45,000 in interest during the duration of the loan. As a result, the mortgage will be paid off way ahead of schedule.
However, if this is a route you’re considering, you should contact your mortgage lender to ensure the funds are used to pay down the principal amount.
Refinance to a shorter mortgage term
In the simplest terms, refinancing your mortgage is where you get a new mortgage to pay off your old mortgage. Generally, refinancing is used to receive better rates and decrease the overall repayment amount.
Refinancing allows you to potentially save money on interest without using some of the other tactics mentioned in this article. Additionally, refinancing provides you with the opportunity to pay off your mortgage at a much faster rate.
While refinancing your mortgage to a shorter term has many upsides, one of the most significant downsides is your monthly payment may increase.
Ready To Refinance Your Mortgage?
Paying off your mortgage early has a lot of benefits as well as drawbacks. Before you move forward with any decision, you should carefully evaluate your financial situation. If you feel that making the move to pay your mortgage off early is beneficial, use these tips mentioned in this article to help guide you through the process.
If the refinance tactic is the avenue you wish to pursue, consider refinancing your mortgage with Arizona Central Credit Union. We offer some of the best rates throughout the Grand Canyon State. Contact one of our mortgage specialists today to see how we can help put you on the path toward becoming debt-free.
