Should you Pay off your Mortgage Early?
Congrats! You bought a house! That’s amazing! Of course, now you have this large debt burden hanging over your head for the next 15 to 30 years and you’re a little worried. You’ve considered trying to pay it off early but not sure that’s the best idea. Well, if you’re wondering if you should pay off your mortgage early, the answer is; it depends. There are a lot of factors to consider and first involves understanding how your Mortgage works.
How does a Mortgage work?
To put it in simple terms, you get a mortgage by telling the bank you want to buy a specific house for a specific price. Then, they make sure you’re financially stable and trustworthy enough to be given such a large loan and they look at the house to see how much the house is worth according to them. After that, if you’re eligible, they’ll give you a loan up to the amount they think the house is worth and you pay that loan off over a specific amount of time at a specific rate. Again, that’s the simple version and doesn’t go into fixed or variable rates, discount points, credit searches and all the steps for closing, but that’s the basics.
So, what probably wasn’t explained in depth is how those monthly or bi-weekly payments you make go towards paying off your debt. The payments are broken down into paying off your principal, the total original value of the loan minus previous payments, and your interest, the additional charge for the loan valued at the established interest rate. Well with a mortgage, a higher portion of your payment will go towards paying off interest over principal in the early years. Then, it flips around half way through the length of your mortgage and you end up paying more principal later on. This can be found for your specific loan by looking at the Amortization Schedule, which is your schedule to pay off the loan. For an example here, here is what the first year and last year of a $200,000 30 year fixed loan at 4%;
On this schedule, you end up paying $143,739 in interest over the life of the loan. That’s on top of your initial $200,000. So just for an idea, if you manage to pay off an extra $100 a month towards principal, your loan will be paid off in 25 years and one month and you only pay $116,884 in interest. Here is what the new amortization looks like;
So you were able to save 4 years and 11 months of mortgage payments and $26,855 in interest, but is that worth it for you? Also, if you want to see how your amortization schedule changes with different payments, you can use this Mortgage Payoff Calculator to test different options.
When is Paying it off Early NOT Worth It?
Like we said in the beginning of this post, whether or not to pay off your mortgage early is dependent on your own individual case. So, here are some situations where just paying off your mortgage is likely not in your best interest.
1) If your Loan has a Prepayment Penalty
This is something to be especially aware of if it applies to your mortgage. Some lenders will have a Prepayment Penalty that is usually 1% to 2% of remaining principal. However, these lenders usually only apply these penalties for about the first 3 years of your mortgage and usually only if you pay the mortgage off in full. After 3 years, these penalties generally go away but every loan and every lender is different. Make sure you review the specific terms of your loan before making any additional payments. It’s not worth paying off extra if the lender just charges you more anyways.
2) If you have High Interest Debt
High Interest Debt can DESTROY your financial stability, if you let it. Credit card debt can be one of the most damaging, having interest rates ranging from 13% up to 24%. What’s worse is that the remaining balance will compound interest daily so the payments get higher every single day. Mortgage interest is calculated monthly and set in your amortization schedule. So if you find yourself in a mountain of 24% APR Credit Card debt and you’re thinking you might want to put an extra $100 a month to your 4% mortgage, you’re making a Big Mistake. It may feel good to know you're chipping away at the larger loan, but you’ll be better off and pay less in interest if you pay down the high interest debt first.
As a rule of thumb, pay off your Highest Interest Debt First. That doesn’t mean skip your minimum payments on other loans to pay higher interest faster. That’ll hurt your credit score. Just pay any extra funds you have towards the highest interest debt first.
3) When you’re Living Paycheck to Paycheck
According to a LendingClub report, 61% of consumers stated they were living paycheck to paycheck. Even of those earning $250,000 or more, 36% said they also live paycheck to paycheck. Now, if you have a mortgage and are able to pay some extra towards it, you may not think you’re living paycheck to paycheck, but if you don’t have any Emergency Fund saved up or started any retirement savings, I’m lumping you into this boat. If you tie all your liquidity into the value of your home, you won’t be able to cover an expensive emergency when it happens. So before you start paying down your mortgage, make sure you save 3 to 6 months of expenses as an Emergency Fund in a high yield savings account that you can access at any time. That’s at a minimum. If you don’t have any retirement investments either, like an IRA or 401k, then I would recommend starting those before paying down your mortgage as well. Why? We cover that next.
4) If your Money Grows Faster Working Differently
Since its inception, the S&P 500 has returned an average of 10.5% per year, year over year. The National Average Annual House Appreciation is 3.5% to 3.8%. So, let’s say you managed to pull off a 4% interest rate for a $200,000 loan and the value of your home increases by 3.5% per year. You have an extra $200 a month, or $2,400 a year, to either pay down your mortgage or invest. What should you do? First, let’s compare the homes appreciation to the interest charged:
Annual Appreciation = $200,000 x 3.5% = +$7,000
Annual Interest = $200,000 x 4% = -$8,000
Net Gain = Annual Appreciation - Annual Interest = $7,000 - $8,000 = -$1,000
So, when we compare the two, we see we paid $8,000 in interest but gained $7,000 in value, netting only $1,000 actual loss. Since the Annual Appreciation shouldn’t change, let’s compare paying off the mortgage to investing. We’ll also assume your investments only grow 7%;
Mortgage Payoff
Annual Appreciation = +$7,000
Annual Interest = ($200,000 - $2,400) x 4%
= $197,600 x 4% = -$7,904
Net Gain = $7,000 - $7,904 = -$904
Invested
Annual Appreciation = +$7,000
Annual Interest = $200,000 x 4% = -$8,000
Investment Return = $2,400 x 7% = +$168
Net Gain = $7,000 + $168 - $8,000 = -$832
So, if we invested that money instead of paying it off, we end up saving $72 net overall. That may not feel like a lot, but that’s just for the first year. If we look at the next year, assuming your minimum payments reduce your principal by $3,500;
Mortgage Payoff
Appreciation = $207,000 x 3.5% = +$7,245
Annual Interest = ($197,600 - $3,500- $2,400) x 4% = $191,700 x 4% = -$7,688
Net Gain = $7,245 - $7,668 = -$423
Invested
Appreciation = $207,000 x 3.5% = +$7,245
Annual Interest = ($200,000 - $3,500) x 4% = $196,500 x 4% = -$7,860
Investment Return = ($2,400 + $168 + $2,400) x 7% = $4,968 x 7% = +$348
Net Gain = $7,245 + $348 - $7,860 = -$267
Now you can see investing would save you $156 net. The net keeps increasing year over year, thanks to the power of compounding.
So, to simplify this, if your money will make more money for you by investing it than it will save you in interest, it’s better to invest that money. Generally speaking, if your mortgage interest rate is 4% or lower, your money will earn more in the stock market than it would paying off interest. In fact, depending on appreciation, your home may even grow more in value than you end up paying in interest.
When is Paying it off Early Worth It?
So now that we discussed all the reasons not to pay off your mortgage early, when would be a good time to start paying a little extra?
1) If you plan to Retire in that House
If you know for a fact this is your “forever house”, paying off the mortgage earlier can be a good idea. If you can afford to pay more now, you could reduce those 30 years of mortgage down to just over 25 years, like in our example or even less. This sets you up for retirement by cutting out what is usually the highest monthly expense for people and lets your saved retirement funds go further. Imagine going from $5,000 a month in expenses to just $3,000. That would be huge, especially on a fixed income! Also, as you approach retirement, it’s better to try to eliminate as much debt as possible while you have steady income in order to keep your expenses low when your income decreases.
2) If you have a High Mortgage Interest Rate
Just like we discussed in the reasons for why not to pay off your mortgage early, the opposite may hold true if your Mortgage Interest Rate is very high. If you’re paying 7% or more in interest each month, it may make sense to try to pay that principal down because you may be losing more money to interest than you could make in other places.
Of course, that will all depend on your home's appreciation, how the stock market is doing, and how much extra you can afford to pay down. Also, since paying down your principal early doesn’t reduce your monthly minimum, it may make more sense to just pay the minimums and refinance into a lower interest rate when interest rates drop or your credit score improves. Refinancing should also reduce your monthly because you could now have a new 30 year at a substantially lower principal.
The Wrap-Up
We touched on a lot of reasons for why or why not to pay off your mortgage early. Some takeaways I hope you remember are;
Some Mortgages have Prepayment Penalties. You need to be aware of your loans conditions before making early payments
High Interest Debt can DESTROY your financial stability, so paying that down should be your first priority
Even high earners can live paycheck to paycheck. Having liquidity in an Emergency Fund is vital to protect you in case of a severe financial loss
Your money can make you much more than you lose in interest. Put your money towards the highest return percentage
If you’re about to retire, it may be worth eliminating that monthly expense. The less you pay monthly to live, the further your money can go
If you have a high interest rate, remember that you can refinance when rates drop. This can even reduce your monthly minimum.
Most important to remember is these situations are not all encompassing, nor do they account for every possible option. Your situation may be totally different than any listed above or even the same. Either way, the best thing to do to determine if you should pay down your mortgage early is to contact a Certified Financial Advisor who can help you decide on the plan that’s right for you. Still, Financial Literacy is the Number 1 Key to Financial Success, so keep learning!
*Disclosure* This is NOT financial advice and I am NOT a Certified Financial Planner. All information is provided for educational purposes only and is not to be construed as advice. Everyone’s financial situation is different and requires individualized planning. Seek out a Certified Financial Planner for assistance with your own financial situation.
