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Should You Pay Off Your Mortgage Early?
By Martha C. White MONEY RESEARCH COLLECTIVE
The idea of getting rid of your monthly mortgage payment might sound pretty appealing. You can free up money in your household budget for other uses, save potentially thousands of dollars in interest payments you would otherwise pay over the term of the loan and enjoy the peace of mind that comes from owning your home outright.
A mortgage paydown might seem like a no-brainer if you get a big bonus, inheritance or other windfall that gives you the opportunity to reduce your debts. Yet there are pros and cons to weigh before you take the plunge.
Read on for the financial considerations you should take into account if you’re weighing whether to pay off your mortgage early.
Table of contents
- Should you pay off your mortgage?
- How to pay off your mortgage early
- Summary of Should You Pay Off Your Mortgage Early
Should you pay off your mortgage?
The first consideration when considering whether to prematurely pay off your mortgage is what might lie ahead for you financially. You need to weigh if your finances will be ready for what else might happen in your life.
For example, don’t clear your mortgage without being confident you can maintain sufficient cash reserves in your emergency fund for an unexpected loss of income, major home repair or other drain on your finances. (Historically, personal finance experts have suggested keeping between three and six months’ worth of expenses in a savings account. But in light of the current economic volatility, the rising cost of servicing high-interest credit card debt and the resumption of student loan payments, six to nine months’ worth might be more prudent.)
The biggest argument in favor of paying off your mortgage early is the potential to save thousands of dollars — even tens of thousands, if you have a large home loan — you would otherwise pay in interest.
You can use this mortgage payment calculator to estimate how much you might save based on the type of mortgage loan, the size of your loan and your interest rate. But let’s outline one scenario to help illustrate how much you can save by living mortgage-free.
If you purchased a house for $300,000, with a 20% down payment, and had a typical 30-year, fixed-rate mortgage with a 4% interest rate, your monthly payment (excluding real estate taxes) would be roughly $1,145. In this example, if you were to stay in the home until you paid off the mortgage, you would pay a total of $172,487 in interest over the course of that 30 years.
That figure is a function of amortization, the repayment structure to which the vast majority of fixed-rate mortgage loans conform. With an amortizing mortgage, the interest you pay back is front-loaded: In the early years of repayment, most of your monthly payment goes towards interest, with just a small fraction assigned to paying down the actual principal.
As you pay down the loan, then, an increasing amount of your monthly payment goes towards the principal. The later in its term a mortgage is paid down, then, the less you’re likely to save in interest – because the monthly payments are largely devoted to discharging the loan principal.
Pros and cons to paying off your mortgage early
- Eliminate your mortgage payments
- Own your property free and clear
- Increase your free cash flow
- Potential prepayment penalties
- Lose eligibility to claim mortgage interest towards your tax refund
- Potential credit score drop from closing an account (the record of your mortgage will remain on your credit report under your list of closed accounts)
- Accessing liquidity tied up in your house can cost you time and money
Prepayment penalties
Mortgage prepayment penalties can significantly detract from the financial benefit of paying off your mortgage early, so this potential drawback deserves a closer look.
A prepayment penalty is a fee levied by mortgage lenders intended to disincentivize homebuyers from paying off their mortgage early, so the lender can collect the maximum amount of interest. Ideally, you should find out before you take out a mortgage whether or not, and under what circumstances, the lender charges prepayment penalties.
Ideally, when you first started shopping for a home loan, you looked for the best mortgage lenders, which are less likely to charge these kinds of fees. And such fees aren’t even allowed for certain mortgages. Some states have laws that bar lenders from levying prepayment penalties. Prepayment penalties are prohibited by law, in all states, on FHA and USDA loans. Additional laws regulating how much mortgage lenders can charge for prepayment penalties cap the amount at 2% of the loan amount, and prohibit them entirely if you have been paying off your mortgage for at least three years.
Mortgage vs. investments: Factors to consider
Deciding whether or not to pay off your mortgage early is a choice you can’t make in a vacuum. All other things being equal, you should weigh the benefits of using that money in other ways, like investing it in the stock market. Paying off your mortgage might give you peace of mind, but basing such a big financial decision on emotions isn’t smart. You’ll need to do some math and figure out where those funds can get you the best benefit for your situation.
If you’re weighing investing versus paying off your mortgage, consider how much you’re paying in interest (and private mortgage insurance, or PMI, if that’s also an expense you have to pay).
If you’re one of the many people who recently bought a house or refinanced to increase your mortgage affordability, it might not make sense to pay off your mortgage — especially if, like the vast majority of homeowners over the past several years, you opted for a fixed-rate mortgage when current mortgage rates were at a historic trough. Sure, you might net 3% or 4% in interest savings, but even when stocks are volatile, it’s very likely that you’ll be able to achieve higher after-tax yields (otherwise known as “rate of return” or RoR) than that in the market, even if you invest conservatively.
Here’s an example of how the numbers might work, starting with the above example of a $240,000 mortgage at a fixed 4% rate. At the outset, if you started paying an additional $500 every month towards that principal, you could pay off your mortgage entirely in 20 years instead of 30, and you would pay $109,045 in total interest — a savings of $63,422.
But say you took that extra $500 monthly payment and invested it instead. At the end of 20 years you’d still have your mortgage, but assuming a consistent 7% rate of return, compounded annually, those investments would be worth $247,908. Sure, you’d forfeit saving that $63,422 in interest, but even if you subtract that cost out, you’d still come out ahead by $184,486.
This might seem like a no-brainer, but those returns are far from a sure thing, as investors who have lived through a significant drop in the market can attest.
Tips if you choose to invest in the stock market
You need to take the time to know what you’re investing in: Make sure you understand the risks of investing and how to diversify your portfolio to hedge against risk. Consider seeking out a robo-advisor, certified financial planner or brokerage firm to guide you, especially if you’re new to investing.
Tools and educational resources can help you do your own research, too. For example, using a compound interest calculator can help you to compare apples to apples.
If you want to make money from the market rather than paying off a mortgage early, you also need the discipline to invest that money consistently over the years, and resist the temptation to tap it for other expenses.
Even if you plan to invest it all, you still lose some of the benefits of annual compounding. And you also need the determination to stick with your investing plan. Markets can be volatile, so you need to make a long-term commitment to your investing plan, or you might make the mistake of bailing out at exactly the wrong time.
An analysis of the S&P 500 over a 20-year period found that seven of the index’s best days took place within two weeks of its 10 worst days. If you think you’d be likely to panic and yank your money out of the market at the first sign of trouble, you might be too risk-averse for this plan to work for you. In your case, committing extra cash to the tune of $500 a month towards paying down your mortgage might be a better option for you.
While your mileage may vary, as the saying goes, here is a broad overview of the pros and cons of investing:
- Potentially higher rate of return (especially if you have a low fixed-rate mortgage loan) can help hedge against inflation
- Assets remain more liquid than if they were tied up in your house
- Can sell your assets for extra money in case of an emergency if investments are held in a taxable account (versus a traditional tax-deferred retirement account like an IRA or 401(k)), provided you meet the criteria for a Roth account and have fulfilled the five-year holding requirement)
- Returns are not guaranteed
- Market volatility can cause you to lose value, especially over the short term
- Fees can decrease your returns (look for funds with low expense ratios and accounts that offer free trades)
Whether you plan to pay off your mortgage early or invest in the stock market, the earlier advice about first establishing an emergency fund holds true: Make sure you first have a financial cushion in place. It’s a bad idea to have all of your liquid assets tied up in either the market or in your home. If you subsequently need cash quickly, you want to have ready access to that money.
How to pay off your mortgage early
If you decide to pay off your mortgage before it’s term is up, a few different strategies will enable you to do so.
Make additional payments
If you don’t have the cash on hand to eliminate your mortgage in one fell swoop, you can work away at that debt a little at a time by making extra payments. There are two main options for doing that.
Choose a biweekly payment schedule
If you pay half of your monthly mortgage payment every two weeks, the total amount submitted will add up to one extra mortgage payment over the course of a year. This might seem like small potatoes, but that strategy presents a nearly painless way to pay off your mortgage more quickly, a little bit at a time. Those 26 half-payments will add up to a total of 13, rather than 12, monthly payments by the end of the year – and so allow you to pay off a new “30-year” mortgage in twenty-seven-and-a-half years.
Be aware, though, that some mortgage lenders might charge you a fee if you want to pay on a biweekly basis. And if your lender’s website or app doesn’t have a feature that lets you automate those payments, you’ll have to remember to make all 26 of those payments every year manually — so make sure you have a foolproof method for reminding yourself so you don’t inadvertently miss a payment.
Pay extra each month
The second — also very simple — way to pay down your mortgage faster is to pay more than your required payment each month (like the example provided earlier in this guide). If you have a conventional home loan with a mainstream financial institution, you will almost certainly have the ability to increase your payments by an amount of your choosing.
One way to approach this is to divide your monthly payment by 12, then add on that extra each month. At the end of the year, you will have made the equivalent of 13 mortgage payments, the same as if you committed to a biweekly payment schedule as outlined above.
If you have the money in your budget, you can even increase your monthly payment by enough that you can effectively turn a 30-year loan into a 15-year loan. Of course, if your budget permits, consider a 15-year mortgage in the first place when you are shopping for a mortgage or looking to refinance, since the mortgage interest rate on 15-year mortgages is usually a bit lower than the rate for a 30-year mortgage. (However, accomplishing the same end via voluntary top-up payments gives you the flexibility to revert to your initial payment amount if your finances change significantly.)
Direct payments to your principal
If your income varies substantially over the course of the year — say, if you own your own business or typically earn annual or quarterly bonuses — you might want to make additional lump-sum payments directly to your principal in order to pay off your mortgage more quickly.
Since your ordinary monthly mortgage payment consists of principal and interest, as well as potentially property taxes, mortgage insurance and other fees, making direct principal payments will help you pay off your mortgage faster. The advantages are that you will build home equity more quickly and save money on interest payments in the long run. If this is your plan, make sure your provider knows that you want your additional payments to go wholly towards your principal.
True, this move doesn’t give you the same kind of financial impact as, say, paying off your mortgage in half the time or taking 10 years off the life of the loan. But making direct payments to the principal when you can will still help reduce the amount of interest you have to pay – by shrinking the principal that’s subject to interest – and free you from the monthly obligation of having to make mortgage payments more quickly.
Consider a mortgage refinance
Mortgage rates climbed quickly in 2022, as a result of Fed rate hikes, but they still remain at relatively low levels.
Maybe you’re wondering, is now a good time to refinance? The answer is: It depends. If you’re paying a higher interest rate than today’s rates — which were about 5% in the late summer of 2022— or if you have an adjustable-rate mortgage that is going to reset at a higher rate soon, you might want to refinance your mortgage in order to lock in a lower rate.
If you want to save money on your payment each month, you can check out this guide to the best mortgage refinance companies. Another money-saving tactic is to refinance into a shorter loan term — the interest rate is typically a bit lower, and paying off your loan faster could save you thousands of dollars in interest over the life of the loan.
As a rule of thumb, the best time to refinance is when you can lower your interest rate by at least 0.75 percentage points, and when you are planning to remain in the house for at least a few more years — long enough that you can recoup the closing costs via the lower interest rate. If you’re looking for more mortgage refinance tips, a good place to start is by using a tool like a mortgage refinance calculator to help you decide.
Summary of Should You Pay Off Your Mortgage Early?
- You can save money on interest by paying off your mortgage early. Late in the mortgage term, payments almost entirely pay down the principal.
- Determine if your lender will charge you a prepayment penalty and the impact of losing your tax deduction.
- Consider if investing might be a smarter financial decision than paying your mortgage off early.
- You can pay off your mortgage loan faster if you add an extra monthly payment each year.
- Paying off your mortgage early can slightly affect your credit because it will represent a closed account.
- Tools like a mortgage calculator or a mortgage payoff calculator are useful for determining the most financially beneficial choice for your circumstances.
- A mortgage refinance checklist can help you decide if refinancing would be a good idea for you.
