If you can afford to pay off your mortgage ahead of schedule, you’ll save some money on your loan’s interest. In fact, getting rid of your home loan just one or two years early could potentially save you hundreds or even thousands of dollars. But if you’re planning to take that approach, you’ll need to consider if there’s a prepayment penalty, among other possible issues. Below are five mistakes that you should avoid when paying your mortgage off early. A financial advisor can help you figure out your mortgage needs and goals.
How to Pay Off Your Mortgage Early
Paying off your mortgage sounds like a dream, being able to own your home outright without making a payment to a financial service provider every month. Before digging into the biggest mistakes people make when paying off their mortgage early, it’s important to understand how you can pay it off early because there is more than one way.
The simplest method is just to make extra payments outside of your normal monthly payments. Provided this route doesn’t result in extra fees from your lender, you can send 13 checks each year instead of 12 (or the online equivalent of this). You can also increase your monthly payment. By paying more each month, you’ll pay off the entirety of the loan earlier than the scheduled time. Let’s dive into each method of paying off your mortgage early in a little bit more detail.
- Make One Extra Payment Per Year: One way of paying off your mortgage earlier than the term of your mortgage is to make 13 payments per year instead of 12. You can add in the extra payment whenever you want throughout the year and continue to make those regular monthly payments as well. This works well for individuals that get a large sum of money at some point in the year like a bonus at work or a large tax refund.
- Make Mortgage Payments Biweekly Instead of Monthly: A great option for some that live on much less than they make is to make biweekly mortgage payments instead of monthly. This will get your mortgage paid off in half the time of the term of your loan. This isn’t a good option for everyone but it could be a good way to speed up that loan and pay it off early.
- Refinance Your Mortgage Into a Shorter Loan Term: Another option is to refinance your mortgage into a shorter loan term. For example, if you have a 30-year fixed with 22 years left on the loan then you could refinance into a 15-year loan and pay off the balance seven years earlier than you would have. This will also typically lower your rate but increase your monthly payments. You’ll pay less for the home over the term of the mortgage than you would have with the lower 30-year rate.
- Pay Off Your Balance In Cash: If you’re able to save enough money to pay off the balance of your loan in its entirety, then this is an option. This is the option that most people think about when they want to pay off their mortgage early, even though there are plenty of other ways to handle it.
It should be noted that anytime you’re paying more than what is required for your next monthly payment you will need to communicate with your lender that the amount should go towards the principal of your loan. If you don’t do this then the mortgage company will likely apply your extra payment towards your next month and it will just look like you don’t owe your next payment, or not as much.
When to Pay Off Your Mortgage Early
It may seem like a good idea to pay off your mortgage early as soon as you have the right amount of money to do so, but there is more to consider. If you have a strong financial reason to pay off your mortgage earlier than expected then it makes a lot of sense. For example, if you want to retire earlier than expected then you don’t want a mortgage in your retirement years.
However, paying off your mortgage early, no matter how you choose to do it, ties up a significant amount of liquidity that you could use to invest and build more wealth, or save for unexpected hard times. You also won’t be eligible for some tax deductions any longer that you’re able to take when you are actively paying on your mortgage.
Ultimately, the right time to pay off your mortgage early really comes down to your personal financial situation. It needs to be a time that won’t hurt you financially and that benefits you over the long haul. We recommend working with your financial advisor to determine when that time is for your situation.
Mistakes to Avoid When Paying Off Your Mortgage Early
As previously mentioned, it’s not always the right time to pay off your mortgage early. Likewise, you may not always do it the right way. Consider these major mistakes others may make when paying off their mortgage early so that you don’t follow suit:
1. Not Considering All of Your Options
It can be very tempting if you come into some extra money to put that toward paying your mortgage off ahead of time. However, getting out of debt a little bit earlier may not be the most remunerative choice to make. To illustrate this, let’s look at an example.
Let’s say you’re considering making a one-time payment of $20,000 toward your mortgage principal. Your original loan amount was $200,000, you’re 20 years into a 30-year term, and your interest rate is 4%. Paying down $20,000 of the principal in one go could save you roughly $8,300 in interest and allow you to pay it off completely 2.5 years sooner.
That sounds great but consider an alternative. If you invested that money in an index fund that represents the S&P 500, which averages a rate of return on 9.8%, you could earn $30,900 in interest over those same 10 years. Even a more conservative projection of your rate of return, say 4%, would net you $12,500 in interest.
Everyone’s financial situation is unique, and it’s very possible that the notion of being out of debt is so important to you that it’s worth a less than optimal use of your money. The important thing is to consider all of your options before concluding that paying off your mortgage earlier is the best path for you.
2. Not Putting Extra Payments Towards the Loan Principal
Throwing in an extra $500 or $1,000 every month won’t necessarily help you pay off your mortgage more quickly. Unless you specify that the additional money you’re paying is meant to be applied to your principal balance, the lender may use it to pay down interest for the next scheduled payment.
If you’re writing separate checks for extra principal payments, you can make a note of that on the memo line. If you pay your mortgage bill online, you might want to find out whether the lender will let you include a note specifying how additional payments should be used.
3. Not Asking If There’s a Prepayment Penalty
Mortgage lenders are in business to make money and one of the ways they do that is by charging you interest on your loan. When you prepay your mortgage, you’re essentially costing the lender money. That’s why some lenders try to make up for lost profits by charging a prepayment penalty.
Prepayment penalties can be equal to a percentage of a mortgage loan amount or the equivalent of a certain number of monthly interest payments. If you’re paying off your home loan well in advance, those fees can add up quickly. For example, a 3% prepayment penalty on a $250,000 mortgage would cost you $7,500.
In the process of trying to save money by paying off your mortgage early, you could actually lose money if you have to pay a hefty penalty.
4. Leaving Yourself Cash-Poor
Throwing every extra penny you’ve got at your mortgage is an aggressive way to get out of debt. It could also backfire. If you don’t have anything set aside for emergencies, for example, you could end up in a tight spot if you get sick and can’t work for a few months. In that case, you may have to use your credit card to cover your bills or try to take out an additional loan.
If you don’t have an emergency fund, your best bet may be to put some of your extra mortgage payments in a rainy day fund. Once you have three to six months’ worth of expenses saved, you may be able to focus on paying down your mortgage debt.
5. Extending Your Loan Term When Refinancing
Refinancing can save you money in multiple ways, as it allows you to convert to either a shorter or longer loan term, depending on what’s best for you. So if you’re 10 years into a 30-year mortgage term, you could potentially refinance to a 10-year term and shave off 10 years. On the flip side, you could go for another 30-year term to lower your monthly payments.
However, loans with shorter terms tend to have lower interest rates, allowing you to both save on interest and reach full ownership much sooner. In some cases, though, refinancing could cost you more in the long run, especially if you’re planning to extend your loan term. Before you refinance, it’s a good idea to crunch some numbers and figure out whether having a longer mortgage term really makes sense.
Don’t forget closing costs either. If your lender agrees to let you roll those costs into your loan, you could end up paying more money. After all, you’ll now be on the hook for interest on a larger loan amount.
Whether you should pay off your mortgage early ultimately depends on how much money you have to spare, what your alternatives are and other factors that are unique to you. But if it’s something that’s legitimately on your radar, make sure to seriously consider all of your options.
Although often known for their expertise in investing and financial planning, many financial advisors are knowledgeable about mortgages and home purchases. So if you’re struggling to make a decision on your own, consider consulting with a local financial advisor.
Rebecca Lake, smartasset