If you’ve just gotten a raise or come into some money, you may want to use it to pay off your mortgage early. There’s no doubt that owning your home free and clear gives you immense peace of mind. However, there may be better ways to utilize your windfall than making extra mortgage payments. Investing money in the stock market, for example, usually yields a higher return than retiring a mortgage with a low interest rate, so before you pay off your mortgage early, consider whether or not it’s the right financial decision for you.
Should you pay off your mortgage faster?
How do you pay off your mortgage faster? Well, before you start putting extra money toward your mortgage, make sure that you’re in a good financial position to do so. It may make more sense to pay off high-interest debt from credit cards, save up an emergency fund and make regular contributions to your retirement accounts instead.
“As a fee-based retirement planner, one of the saddest things I deal with are folks who paid off their home at the expense of retirement savings. They retire, and after some years, find they do not have enough income to stay in the home and end up forced to sell,” Roger L. Gainer, ChFCR; RICPR of Gainer Financial & Insurance Serv., Inc., said.
If you’ve already done those things and you have some extra cash on hand, paying off your mortgage faster could be a good choice. Aggressively paying down your debt could save you tens of thousands of dollars in interest. Once your mortgage is finally paid off, you’ll have much more breathing room in your monthly budget. You’ll be able to put that extra discretionary income toward important, long-term financial goals such as buying an investment property or retiring.
Paying off your mortgage early will also give you peace of mind. Being completely debt-free can make you feel much more secure. No matter what happens in the future, you’ll always have a place to live, which is pretty reassuring.
With that being said, there are some convincing reasons not to pay off your mortgage early. If you invest your discretionary income in the stock market instead of putting it toward your home loan, you will often get a better return because mortgages have such low interest rates.
Right now, the average interest rate on a 30-year fixed-rate mortgage is 3.73%. The stock market’s average annual return is much higher at 10%. Though you’ll save thousands of dollars on interest by paying down your mortgage early, the return you’d get from investing is likely to be much larger.
Another reason not to pay off your mortgage is that it ties up a big chunk of your money in a non-liquid asset. If you ever need money, it could take months or even years to sell your home and access those funds, which could be an issue. It’s also unwise to have most of your net worth tied up in a single investment. If your home depreciates and you have to sell it, you could end up losing a large percentage of your wealth.
One last thing to consider is that mortgage interest is tax-deductible. Before you consider paying off your mortgage early, make sure you talk to a financial advisor to determine how much more you’ll have to pay in taxes each year.
“You finance your house no matter how you pay for it. You either take out a mortgage and pay interest to someone else or you self finance by paying cash and giving up the potential to earn interest long term,” says Garrett Konrad, partner at registered investment firm IFC.
Ways to pay your mortgage off early
There are many approaches to paying off your mortgage early.
“The best way to pay off your mortgage early is to add an extra amount to your principal balance each month,” Phil Gergiades, Chief Real Estate Agent for FedHomeLoanCenters.org, said.
Compound interest can be reduced by thousands of dollars and pay off your mortgage several years ahead of schedule by paying as little as fifty dollars extra per month. An extra payment of $50 per month on a 30-year, $200,000 mortgage with an APR of 3.5%, will reduce your mortgage balance by $12,356 and reduce the payoff time by 2 years and 7 months, Gergiades said.
Doing this at the start of your mortgage when you’re paying the most interest will help you build equity faster and reduce the term of your loan.
Another option is to switch from monthly payments to biweekly payments. Instead of making 12 full mortgage payments a year, you’ll make 26 half-payments. This slight change to your payment schedule will result in you making one extra mortgage payment each year. This will save you thousands of dollars on interest and shave years off your mortgage, all without drastically changing your monthly budget.
Some lenders don’t accept partial payments or charge a processing fee if you choose to pay biweekly. In that case, it’s better to make an extra mortgage payment once a year to shorten the term of your loan.
Furthermore, you can consider not sending extra payments to the bank or mortgage company. Instead, take the longest payment period possible (often 30 years), compare that payment to the payment for a mortgage that would be paid off in your desired time frame (e.g., 15 years), then deposit the difference in an account you control that earns interest.
“Given today’s rates, if you earn at three percent on the deposits, you will be able to pay off the balance in less than fifteen years. The benefit is that you control the equity, not the bank,” Gainer said. “The portion of your payment that is principal, once paid to the bank can no longer earn any interest — home equity always earns a zero percent rate of return — and is illiquid.”
The benefits of this strategy include controlling the principal, having a better tax deduction and if you lose your job, it will be easier to make the lower payment and not lose your home.
When you shouldn’t pay off your mortgage early
More than five million Americans are underwater on their mortgages, which means they owe more than what their homes are worth. If you’re one of them, you may be tempted to make extra mortgage payments to build equity and dig yourself out faster. However, you’re probably better off putting that money into a more stable investment vehicle such as a retirement account. Your home’s value may recover over the next few years, but there are no guarantees. You’ll likely see a better return on your money if you invest it in the stock market, which has been shown to give fairly consistent annual returns.
If you’re seriously underwater on your house, meaning you owe at least 25% more than what it’s worth, you may even want to consider walking away. If you sell your home at a loss through a short sale, some lenders will forgive the rest of your debt. You may also be able to hand over your home’s deed to the lender in order to get out of the mortgage. Unfortunately, however, some lenders won’t work with you, which may force you to foreclose on your home.
A foreclosure occurs when a homeowner stops making payments on a home. The lender repossesses the house and sells it in order to recover some of the outstanding debt. Foreclosing on a home will severely damage your credit and make it very difficult to qualify for loans and credit cards in the coming years. If potential employers check your credit report and see the foreclosure, it could even hurt your chances of getting a job. You’ll also have to wait at least a few years before you can buy another home. Still, if you’re so underwater on your mortgage that there’s little chance of recovery, it may make more sense to foreclose than to keep throwing money at a bad investment.
Alternatives to paying off your mortgage early
If you’re wondering how to pay off your mortgage faster while still having enough money to invest, we may have an answer. Refinancing your home into a shorter-term mortgage when interest rates are low could allow you to clear your debt ahead of schedule without increasing your monthly mortgage payments. You’ll still have money left over every month to invest in the stock market, and you won’t have to put off your dreams of being debt-free.
Another way to pay off your mortgage early without using up all of your discretionary income is to downsize. If you sell your current home and buy a cheaper one, you’ll be able to pay off the mortgage faster while keeping your monthly budget the same.
The bottom line
While there are some disadvantages to paying off your mortgage early, such as missing out on stock market returns, it’s still a smart decision in some situations. As long as you’re in a good place financially and you’re not neglecting other long-term goals like retirement, paying a little extra money on your mortgage each month won’t hurt.