When and How to Pay Off Your Mortgage Early

There are a lot of conflicting ideas about whether or not paying off your mortgage early should be a top priority. A family member might tell you paying off their mortgage was one of the best moments of their life, while a friend warns you that paying early is a mistake. With financial gurus on both sides of the fence, it can be hard to know what to do. So, what's the right move today—pay off your mortgage early or don't worry about it?

Should I Pay Off My Mortgage Early?

Unfortunately, there is no one-size-fits-all answer to this question. The right choice depends on what's most important to you and what stage of life you are in. If you are a first-time buyer with many competing financial priorities (and plenty of time to earn and invest), your considerations will be different from empty-nesters with a lot of savings and a fixed income. Everyone's situation and priorities are different.

If you are thinking about paying off your mortgage sooner than planned, either by changing to a short-term loan or sending extra payments to your lender, you should first ask yourself these five questions:

1. Do I have an emergency fund? Before deciding to shorten your mortgage term, many experts suggest creating a cash cushion to cover unexpected expenses, such as a burst pipe or termite invasion. Without an emergency fund, you could find yourself borrowing more money at a much higher interest rate to handle an unforeseen financial crisis.
2. Have I maxed out my retirement accounts? Whether it's a 401(k), an IRA, or another type of retirement account, maxing out your retirement savings should be a top priority. Putting a substantial amount of money into your retirement fund is even more beneficial if your employer matches part or all of your financial contributions.
3. Do I have enough saved for my child’s education? If you have children and plan on paying for part or all of their college tuition, you may want to invest in a 529 plan. Under the 529 program, you can put money into a mutual fund or similar investment, and your account will be protected from both state and local taxes.
4. Do I have other debt to pay off? It's important that you focus on paying off all of your other debt obligations before increasing your monthly mortgage bill. Credit card debt can really add up over time, especially when you consider interest rates and other fees. For example, a mortgage at 4% interest is less expensive than a credit card debt with a 22% interest rate if you’re only making the minimum payment, so you should consider paying off the credit card before the mortgage.
5. Do I understand the terms of my mortgage? Before you decide to switch to a short-term loan or send additional mortgage payments to pay off your mortgage early, be sure to look closely at your loan documentation to ensure that you’re aware of any prepayment penalties that may apply.

Paying Off Your Mortgage Early: Pros and Cons

Once you have asked yourself the five critical questions above, you should have a better understanding of your financial obligations and goals. From this informed position, you can consider whether paying off your mortgage fits into your plans. Choosing to pay off your mortgage early has both advantages and disadvantages. Here are the significant benefits and drawbacks to consider:

Pro #1: Peace of Mind

Once you no longer owe your lender, you will own your home free and clear. For many people, you can't put a price on feeling that sense of financial security and freedom.

Pro #2: Paying Less Interest

In a typical 30-year, fixed rate mortgage, the borrower will actually pay more in interest than principal over the life of the loan. By increasing your payment amount, you get to pay more principal earlier on. As a result, you can significantly reduce your interest payments. This will allow you to build equity faster, enabling you to own your home outright sooner.

Con #1: Limited Investment Options

Mortgages currently remain at historically low rates, usually with an interest rate that's less than what you could average in retirement or investment accounts. For example, if you pay off a 5% mortgage with money that you could otherwise put in an investment account that typically earns around 10%, you are actually losing 5% on that money. If you have a low interest rate on your mortgage and few other investments, you might benefit more from putting your extra money in a Roth IRA, 401(k), or index fund, all of which can offer a higher return than paying off your mortgage. You may also want to consult with a licensed financial planner to determine what investment options work best for you.

Con #2: Tax Implications

Not having a mortgage payment might help your budget, but you will also lose the tax deductions available for mortgage interest. If you itemize and have few other deduction options, this is money you might not be able to get back otherwise. Always consider consulting with your tax advisor on what the tax implications would mean to you for paying off your mortgage early.

Con #3: Less Flexibility

If you choose to pay off your mortgage early, you may be giving up some flexibility, since cash that could be easily accessible from a savings account will now be in your house as equity. If your mortgage is paid off and you want to use the equity in your home, you may want to opt for cash-out refinancing, however note that you will need a new appraisal, loan origination fees, and other third-party expenses, plus one to two months for the loan to fund. You may not be able to spare that time or cover those expenses if you’re in a bind.

Four Ways to Pay Off Your Mortgage Early

If you have weighed the pros and cons above, considered your financial goals, and still want to pay off your mortgage early, there are several ways you can get started. For those looking to shorten a mortgage term or increase monthly payments, make sure you examine your loan documentation to ensure you’re aware of any prepayment penalties on your loan.

Next, consider how you would like to approach your early mortgage payoff. Here are four common methods to consider:

1. Make an extra payment

Imagine you have a $300,000 mortgage set up at 4% interest for a term of 30 years. Making one extra payment every year—a 13th month payment—will reduce the term of the loan from 30 years to 25 years and 11 months. You save more than four years’ worth of payments and interest. Make that 13th month payment by dividing the monthly mortgage amount by 12 and adding that amount to each month’s payments.

For that $300,000 mortgage in our example, the amount is an additional $119.36 each month applied to principal. Alternately, if you simply make an extra month’s mortgage payment —$1,432.25—once a year, you’ll have the same effect on your amortization schedule

2. Round Your Payment Amounts Up

Is an extra payment per year is too much? Try rounding up. With that $300,000 mortgage example, take the monthly payment from $1,432.25 and round up to $1,500. The extra $67.75 isn’t a lot, but will bring the amortization schedule down by nearly two years.

3. Make Extra Lump Sum Payments when Possible

Got a huge tax return or unexpected inheritance? Putting additional extra money towards your mortgage debt reduces the length of your loan and the amount that you pay in interest.

If you choose any of these first three methods, make sure to call your lender and find out exactly what you need to do so that your extra payments will be correctly applied to your loan. They may require a note with the extra money or directions on the notation line of the check. In addition, make sure you check the next statement to make sure that your extra payments have been properly applied.

4. Refinance to a Shorter Term Loan

If you have 30-year, fixed-rate mortgage for $200,000 at 4.5% that you refinance into a 15-year loan at 4%, you will pay off that mortgage 10 years earlier and save more than $60,000 in interest. Refinancing is the most powerful of these methods, but it can be complex and does require you to pay closing costs. It’s also less flexible than the other two methods Once you refinance to the higher payment amount, you must keep making that payment.

A Powerful, Personal Decision

Paying off your mortgage early is a complicated decision that may give your more freedom in many areas, but can also limit you in others. Take your time to consider your goals and calculate your potential savings. Most importantly have a talk with your lender, or with a Pennymac Loan Officer, to determine if an early mortgage payoff makes sense for you.