To figure out whether early repayment is for you, you’ll need to do some basic calculations and weigh up the pros and cons.
Why Would You Consider Paying off Your Mortgage Early?
For most people, the largest purchase you will ever make is buying property, usually your home. With most fixed-rate mortgages lasting for 15 to 30 years, finally paying off a home loan can seem like a major financial and psychological achievement. Of the 73.3 million owner-occupied housing units in the United States, only 26.9 million homes (about 37%) were owned free and clear of debt, according to a 2016 report by the non-profit Urban Institute. For homes owned free of debt, average net housing wealth (or average home equity) was $229,296. For those with debt, average net housing wealth was just $104,932. That is a big difference in terms of the value of your largest asset.
The Pros and Cons of Early Mortgage Repayment
Sense of accomplishment
Drain on emergency funds
Build home equity
Money could be invested elsewhere
Eliminate some interest payments
Lose tax deductions
Frees up cash flow
|Sets you up for better refinance rates in the future|
The benefits of early repayment are fairly self-evident: by making extra payments, borrowers build home equity, and reduce their interest payments. Perhaps the biggest benefit is it frees up cash flow for other things, meaning the money you were spending on paying off the mortgage can instead be spent on fun things like going to restaurants and taking vacations, or things you need, like medical expenses or college tuition. Finally, when your home equity increases, your LTV (loan-to-value ratio) decreases, putting you in a stronger position to refinance, or take any other kind of loan, at better rates.
Digging into your savings to pay your lender has risks and downsides, too. It reduces the amount of funds you can fall back on in the event of an emergency. It’ll mean giving up on future mortgage interest deductions. You may have to pay your lender early repayment penalties. And you might be better off investing your funds in something where there’s a good likelihood of earning a higher rate than what you pay on your mortgage, or that appreciates faster than your property does.
What to Consider
- Opportunity cost: Before putting all your savings toward early mortgage payments, it’s worth asking yourself whether the money would be better invested elsewhere.
Let’s say you’re locked into a low mortgage rate of 4%-5%. There are many low-to-medium risk investment paths that offer a decent likelihood of earning more. For example, the stock market has averaged an annual return of about 10% over the past century and 14% over the past 5 years. With interest rates now at their highest point since 2008 and expectations the Fed will continue to hike rates, it may soon be possible to lock your money into a no-risk term CD at an equal or higher rate than your mortgage rate.
- Tax deductions: Mortgage payments are tax deductible, so paying off your mortgage early means you’ll lose those deductions in future years when you’re no longer making payments.
As always, you’ll need to make your own calculations to figure out whether or not you can afford to lose this benefit. The following numbers can guide you. Let’s say you’re an individual earning $38,700 to $82,500 per year (or a married couple earning double that). You’d be paying 22% income tax, so for every $100 you put down on your mortgage you’d get back $22 in tax deductions. However, the standard deduction is $12,000 for individuals and $24,000 for couples, so you could only deduct mortgage payments above that amount—and only if you itemize your tax return using IRS form 1040 (possibly with the help of an accountant).
- Inflation rate: This is one factor many people overlook when considering early payments.
Inflation rose 1.61% annually between 2008 and 2018, meaning goods costing $100 in 2008 would cost $117 in 2020. If you had $100 in cash in 2008, that same $100 would effectively be worth around $85 today. With a fixed-rate mortgage, you pay the same amount every month for the duration of the loan. Higher inflation causes your money to lose value when you buy groceries, petrol, or concert tickets, but your money maintains the same value when you make your monthly payment because the cost of a fixed monthly payment never increases. Therefore, allocating your spare cash to other goods and services rather than allocating it to early mortgage payments is an effective way of protecting yourself against high inflation.
How Much Can You Overpay?
The biggest mortgage lenders make tens of millions of dollars each year on interest, so you can be sure they’ll probably charge you for paying off your loan early. Some banks charge a fee if you make an extra payment in a given month or if you make a principal-only payment (as opposed to a payment that covers principal and interest). These fees vary from bank to bank. Therefore, before overpaying, it’s important that you read over the terms of your loan carefully.
How Much Can You Save?
A number of factors go into determining how much you can save by paying off a fixed-rate mortgage early, including your interest rate, years remaining on your mortgage, and the amount you add to your principal payment.
For a 30 year loan for $200,000, you can see the savings here:
|Years Left||Interest Rate||Additional Principal Payment||Total Savings|
So, Should You Pay Off Your Mortgage Early?
As this article demonstrates, deciding whether or not to pay off your mortgage early requires a good deal of thought. If you have spare funds but can make more money investing it than you can save paying off your mortgage early, then it might be wise not to overpay on your mortgage.
But if you’re likely to save more from overpaying on your mortgage than from investing your funds elsewhere, or if you value becoming sole owner of your home and canceling out your debts—then you should pay off your mortgage early.
Mortgage Early Payment Q&A
- How do I overpay on my monthly mortgage payments?
The best way to start overpaying is by reading over the terms of your mortgage and calling your lender. By speaking to your lender, you can check if there are any penalties for overpaying and ensure your extra payments go toward reducing the principal.
- Is it worth asking my lender to reduce the term?
If you’re planning to pay off your mortgage early, there’s generally no need to ask the lender to reduce your term—as overpaying will effectively bring your term to an early end anyway. If you ask for a shorter term, your lender might lock you into higher monthly payments. But if you overpay one month and find you’re unable to overpay the following month, you can bring your payments back to the original amount and end your term on schedule.
- What alternatives are there to overpaying?
If your mortgage is proving too expensive, one option is to refinance the loan with better terms. Refinancing involves getting a new lender or your existing lender to agree to pay off your old mortgage, and in exchange they give you a new home loan at a lower rate. You might qualify for a lower rate today if your mortgage started during a period of high rates or if your credit score has improved since you first signed your mortgage.