Homeownership is a significant milestone for individuals and families. For most people, a house is the biggest purchase they’ll ever make. To make that purchase, the prospective homeowner will likely have to borrow money in the form of a mortgage.Â
Mortgages are large loans that could last for two decades or more, and the cumulative payments far exceed the sticker price on the home because of one thing: interest. Although the purchase price is crucial, the reality is that the mortgage terms you’ll secure and negotiate depend on your financial situation.
As such, the prospect of paying off a multi-decade mortgage can be daunting. Given the financial burden attached, many are curious about the benefits of paying down their mortgages faster.
One of the first things you need to ask is whether paying off your mortgage earlier is the right financial decision for you. Yes, it would be a great relief to rid yourself of the pressures of paying off a mortgage. However, to assess whether it’s the best course of action to take at the moment, you need to look at several variables.
Some financial professionals advise you to take your time paying down your home and focus on reaching your broader financial goals. Others advise you to pay off your mortgage early and be financially free sooner to make investments. There is no cookie-cutter formula for paying down a mortgage, especially in the greater context of your finances, but if you find that you can reduce your mortgage’s cost and length, you should consider it.
Accelerating Mortgage Payments: Making the Decision
Paying off a mortgage earlier than initially planned is an excellent way to liberate spending capacity and increase savings. However, important considerations go into the decision to expedite mortgage payments.
In addition, you must be capable of executing the strategies needed to accomplish it. To help you decide whether to accelerate your mortgage payments, you need to take stock of your current financial situation, see the resources you have at your disposal, and assess your goals.
Anatomy of a mortgage
You also need to understand what mortgages are made of. The anatomy of a mortgage can be simplified into principal, interest, equity, taxes, and insurance, plus PMI when applicable. Your principal is simply the amount you borrowed.
Do you need $300,000 to buy a home? Your loan statement will be higher than that, but $300,000 is your starting point and your principal. This principal is the amount that you asked the bank to lend you.
Your interest is the amount you have agreed to pay to obtain your principal. In other words, interest is the rate of money for money. Equity is the amount of value in the house you own.
If your house is worth $300,000 and you don’t owe money on it, then you have that amount of equity in your home. You own that value. If you owe $200,000 on a $300,000 house, you have $100,000 in equity. If you sell the house, you must pay the bank $200,000 back. You keep the remaining $100,000, which is your equity.
When you take out a mortgage, you must pay taxes and insurance. If your lender believes your loan to be a higher risk than most, you will find an extra cost added. It’s called PMI or Private Mortgage Insurance.
Understanding the components of your mortgage will help you understand your payments better and why making payments to the principal makes a crucial difference.
Use a mortgage calculator
You can use a mortgage calculator to visualize where you’ll be in 5, 10, 20, or 30 years. A mortgage calculator helps you simulate scenarios. It is the first step in determining whether accelerated mortgage payments are sustainable for you.
Moreover, it can help you compute how much more to pay monthly to accomplish your goal. It will also help you project the timelines associated with specific amounts. Thus, it enables you to strategize and break down your plan regarding principal and interest. Most mortgage calculators do not factor into account insurance and taxes.
The primary inputs on a mortgage calculator include:
- The original loan amount
- The loan term
- Current interest rate
- Outstanding balance
- Remaining years on the initial mortgage term
- Ideal timeline in years you’d like to pay it off
The original mortgage term is the time on your original mortgage in years. The most common options are the 15-, 20-, and 30-year terms.
The remaining years refer to the years left on your mortgage term. The annual interest rate is the simple interest rate on your loan. It does not include the origination fee, private mortgage insurance, and points paid at the beginning of the mortgage.
Your current mortgage payment is how much you pay monthly on your mortgage, principal, and interest. This payment is based on the original mortgage amount without the taxes or homeowners’ insurance.
The remaining mortgage amount refers to the amount you still need to pay with interest. You should not confuse this with the remaining principal balance.
Should you pay off your mortgage early? More Considerations
With better understanding and information, you can decide whether you can—and should— pay off your mortgage early. There are advantages to doing this.
Paying off a mortgage loan faster than the original term can save you thousands of dollars in interest.
Photo by Paul Kapischka on Unsplash
Early in the loan term, a big chunk of your payment is applied to the interest. However, as time passes, more of your payment goes towards paying down your principal. This amortization process lets the lender earn back a more significant portion of their money in the early years of repayment.
Before deciding to pay off your mortgage early, you need to consider more factors. Review all your outstanding debt, including auto loans, personal loans, and high-interest credit card debt.
Mortgages may carry lower interest than these other types of debt, and it’s generally wiser to start paying off these loans before you focus on your mortgage. Understand the penalties and tax consequences that come with your decision. You should check with your loan servicer to confirm the remainder you must pay.
Moreover, you need to secure your income in the coming years and guarantee sufficient cash flow that will enable you to withstand the temporary strain that larger mortgage payments will exert on your other debts and lifestyle.
Less cash may also mean you have a smaller emergency fund. Evaluate how much money is needed to sustain these payments for the time frame you have planned.
After simulating scenarios with a mortgage calculator, you can decide whether or not you are capable of making larger payments every month. The key strategy to paying off a mortgage early is to make extra payments to your principal. There are several ways to do this.
5 Ways To Pay Off Your Mortgage Early
When paying off your mortgage early is ideal for your financial situation and goals, and you want to experience the benefits of owning your home free and clear, here are five strategies to choose from.
Schedule well-timed additional payments
If you can’t make regular extra monthly payments, you can opt to make well-timed additional payments that will help alleviate your debt and even be more effective. Apply your annual bonuses or windfalls to these extra payments. Doing so over several years can cut your mortgage by a few years and save you thousands of dollars in interest.
The key to these additional payments is that they should be paid towards the principal. Check with your lender and indicate that your extra payments will be credited directly towards the loan principal. If unspecified, your lender is likely to use those funds to prepay the interest on your loan, resulting in less benefit to you.
Pay biweekly
A biweekly payment adjustment can spell a huge difference if multiplied over several years. To pay off your mortgage faster, split your monthly payments into two smaller payments and pay every two weeks. The payments will add up to thirteen monthly payments at the end of the year. This method accelerates the pace of your loan payoff. It also saves you money on interest over the life of the loan.
To better appreciate this strategy, consider how it works on a $250,000 mortgage loan. Supposing it’s a 30-year fixed-rate mortgage at 3.5%, your biweekly payment strategy will save you over $20,000 in interest and cut your timeline by four years.
Recast your mortgage
Mortgage recasting is a way of prepaying your mortgage. To recast your loan, you make a lump-sum payment towards your balance. Because of this payment, the lender re-amortizes the loan with the reduced balance. The recomputed monthly will be lower as a result. With this method, you retain the same loan term and interest rate.
Not all mortgages qualify for recasting. For example, you cannot recast VA, FHA, and USDA loans. Those loans usually require a fee of about a few hundred dollars.
Refinance your loan to a shorter term
When your new income and lifestyle affords it, consider refinancing your current mortgage to a shorter term. Many opt for the 30-year repayment term to keep monthly payments low, but as financial circumstances improve, borrowers can shorten it.
With this home refinance strategy, your monthly payments will increase because the repayment will be crunched to a shorter period. When you refinance to a shorter term, you save on interest, pay off your mortgage earlier, and possibly qualify for a lower interest rate. By reducing your term to 15 years from a 30-year term, for example, you save tens of thousands in interest payments.
Before you refinance, consider the mortgage refinance closing costs, which may negate any interest savings and render the whole strategy moot. You could pay anywhere from 2 to 6 percent of the outstanding principal in mortgage refinance fees or closing costs. These are charges that can quickly add up.
Stick to basics: Add to your monthly payments
This method is the most basic and obvious, yet it goes a long way toward paying off your mortgage quickly. If you make room for an additional $20 or $50 towards your mortgage payments, you can shave off a few years to your term and thousands off your interest.
This method requires little more than discipline in your expenses, like cutting down on luxuries, recreation like dining out, or small purchases like coffee. It doesn’t require too much sacrifice on your part. Diligence in increasing monthly payments pays off eventually and is among the easiest yet most effective ways to pay off your mortgage faster.
It is important to note that as mortgages typically offer lower interest than other types of loans, ensure that your additional payments do not cause you to de-prioritize paying off high-interest loans first or miss out on high-yield investments.
Pay Off Your Mortgage To Be Financially Free Sooner
Paying off your mortgage faster isn’t for everyone. Still, it offers several benefits, including saving money on interest, eliminating monthly payments, and freeing up cash flow toward other things like investments.
It also means you own your home sooner. When you completely own the house, there’s no fear of foreclosure. Being mortgage-free gives you psychological relief and peace of mind, allowing for new investments and financial opportunities.
However, remember the downsides of doing so before you take on the challenge of paying your mortgage quickly using any of the above strategies.
These include less liquidity—resulting in you being financially strapped with less cash to invest, a diminished emergency fund with less to spend on healthcare, having more tax considerations, and potentially incurring fees and penalties. Also, know your priorities: be sure to pay off higher-interest debts first before lower-interest debts.
If you’ve weighed all factors, done your calculations, and found that paying down your mortgage faster is still the best option to reach your financial goals, then all you need to do is start.
Your number one adversary is interest, and your second is time. You must choose the right plan for you, your income, and your financial circumstances to beat these two adversaries.
When you direct your income and resources towards paying off mortgage debt, you’ll find that the financial freedom it affords in the near future will enable you to move on to more extensive plans and significantly add to your quality of life.
