If you’re a homeowner and you have a long-term financial plan, you should include a strategy to pay your mortgage off early. Once you eliminate your mortgage payment, you’ll have more money each month to pay off non-housing debt, build up long-term savings to fund your children’s college education, or prepare for your retirement.
And speaking of retirement, you’ll want your mortgage gone by the time that day arrives; that way, you won’t need nearly as much income, and your retirement portfolio will last much longer.
How to Pay Off Your Mortgage Early
Here are four ways to pay off your mortgage early that you’ll hardly even notice. Use one or a combination of two or more, and you’ll be mortgage-free well ahead of schedule.
Refinance to a Mortgage with a Shorter Term
With mortgage rates currently in the 4.x range, this can be the simplest way to retire your mortgage early. The idea is to refinance your loan but reduce the term by at least five or 10 years. By doing so, you can convert a 30-year mortgage to a 25-year loan or even a 20-year term.
As simple as this method is, there are some caveats to be aware of should you decide to go this route:
- You don’t want to refinance if it will result in an increase in your interest rate of something on the order of one percent or more. There’s a point where a higher rate will offset the benefits of a shorter term.
- You don’t want to add closing costs to the new loan balance – doing so will only increase your monthly payments and make paying off the loan more difficult.
- The term reduction must be based on the number of years remaining on your mortgage as of today. For example, if you are three years into a 30-year mortgage (meaning you have 27 years remaining on the term), and you want to reduce the term to that of a 20-year loan, you’ll have to refinance the new mortgage as a 17-year loan.
Keep each of these points in mind should you decide to make a term reduction refinance. Also, it’s probably not worth refinancing if you expect that you will be moving out of the house in less than five years.
What if you can’t refinance? If mortgage interest rates have increased since you bought your home, you may not be able to refinance your home at a comparable interest rate. In this case, you can simply pay extra on your current mortgage.
Use a mortgage calculator to determine the payment on a 15-year or 20-year mortgage and apply that to your current loan. The additional payments will go toward the principal to help pay off your mortgage more quickly. This also gives you the flexibility to scale back your monthly payments if something should happen and you need the buffer in your budget.
Set up a Bi-weekly Payment Plan with Your Mortgage Holder
With a biweekly mortgage payment, you will make your house payment every two weeks rather than once a month. At first glance, it doesn’t seem as if that will make much difference. But it actually has the effect of making you pay the equivalent of one extra monthly payment per year. And that difference in the annual payment can chop several years off the remaining term of your loan.
For example, if you simply cut your mortgage payment in half each month but make two payments per month, you’d be making 24 payments per year. But with a biweekly mortgage, your payments are made every two weeks, which works out to be 26 payments per year. It’s based on the fact that while you are making two payments every 28 days, there are actually 30 or 31 days in most months.
The net effect is that instead of making 12 payments per year, you’re actually making 13. That 13th payment goes entirely to the principal, which is why your loan pays down faster. On a 30-year mortgage, this will typically take four years off the loan term.
One of the disadvantages to a biweekly mortgage is that if you don’t already have one, you generally will have to refinance your current mortgage in order to establish one. That’s because every small detail of your mortgage is a legally recorded contract; if you change even a single item, you’ll have to change the contract, and that requires a refinance.
Make One Extra Mortgage Payment Each Year
But there’s an easier way to benefit from the biweekly mortgage without having to refinance your current mortgage into one. You can simply make one extra mortgage payment each year, and that will achieve the same result.
There are different ways that you can make a 13th payment each year, but the least noticeable will simply be to allocate extra money into a dedicated savings account – kind of like an emergency fund, but one set up for the specific purpose of making an extra payment on your mortgage each year.
For example, if your mortgage payment is $1,500, you can put $125 ($1,500 divided by 12 months) into the dedicated savings account. Then you’ll have the money available at whatever time of the year you determine as the date to make the extra payment.
Why do this, rather than simply add it to your monthly payment? Because putting money into a savings account seems less painful than increasing your monthly payment. It will also allow you to tap the account should the funds be needed for an emergency purpose. That’s more of a psychological advantage than a real one, but then personal finance always involves an element of psychological warfare – with yourself!
Apply Cash Windfalls to Your Mortgage Balance
This can be the most effective fast-payment method you can use to pay off your mortgage early. That’s because you don’t have to save up for it, you don’t have to increase your monthly payment, and you don’t have to refinance your mortgage. You simply take any extra money you have and apply it toward your mortgage balance. Your regular monthly budget will never be disturbed.
There are probably more opportunities to do this than you are generally aware of. The most obvious is using your income tax refund for this purpose. According to the IRS, the average tax refund is around $3,000. If your refund tends to be in that average range, that will be a more effective way of paying off your mortgage than making extra mortgage payments or even increasing your monthly payment.
But don’t stop with your income tax refund. You can also use bonus money from work or even cash from the sale of any personal effects that you might sell at a garage sale or through eBay or Craigslist.
Downsides to Paying Off Your Mortgage Early
Paying off your mortgage early can certainly help you achieve financial freedom more quickly. However, everyone has different financial priorities, and they should decide if paying their home loan early is the right move for their situation.
Here are some of the downsides to paying off your home early:
Your Equity is Tied up in the Home
When you pay off your mortgage, you are tying up a large amount of money in an illiquid asset. For many people, their home is their most valuable asset and a large percentage of their net worth. This may cause some people financial difficulty if they need quick access to liquid funds.
You May Have Higher Priority Debts to Eliminate First
You should focus on eliminating any high-interest consumer debt you have before making extra payments on your home loan. This includes credit card debt, personal loans, auto loans, student loans, and any other loans you may have. In general, mortgages tend to have relatively low interest rates, making them a lower priority for most people.
You May Be Better off Increasing Your Investments
Being debt free is important. But it’s also important to have investments to cover future income needs. Consider increasing your investments before increasing your mortgage repayment schedule. This is especially important if you aren’t already maxing out your retirement accounts, including your IRA and 401k. Investing in these tax-advantaged accounts can help you supercharge your path to financial freedom.
A Blended Approach May Work Best
Remember, personal finance is personal, so you should find the approach that works best for you. You may find that you want to eliminate your mortgage early than scheduled. But you may also have multiple financial goals, including saving for your child’s college, retirement investing, or paying off loans.
In that case, splitting your efforts and working toward all these goals is perfectly acceptable. Refinancing your home loan may save you thousands if you decrease your interest rate. If that isn’t an option, simply increase your monthly payment. The additional funds will decrease your principal and help you build equity faster and pay off your mortgage sooner.
In Summary – Paying Off Your Mortgage Early Can Be Accomplished
If you get serious in this effort – and put any refund you receive toward your mortgage – you could very well cut a 30-year mortgage into a 15-year mortgage.
Then start thinking about what you can do with all the money you’ll have due to not having a mortgage for 15 years.