The Why and How of Paying Off Your Mortgage Early

Key takeaways

• A mortgage is a house-buying loan, generally with a fixed term of 15 or 30 years of monthly principal and interest payments.

• Paying off a mortgage early may save you money in the long term, and create additional cash-flow flexibility in the short-term.

• You may be able to pay off a mortgage early through methods such as refinancing, mortgage recasting or making additional payments.

• Before paying off a mortgage early, consider prepayment penalties, your liquidity and whether it would entail forgoing other financial goals.

Data from the U.S. Census Bureau shows that about 19% of homeowners over the age of 65 still have a mortgage. While you may consider buying a house an investment, the long-term expense of carrying a mortgage can be overwhelming. In response, you may view paying off a mortgage early as a benefit and signal of financial independence.

Here, we will walk you through different methods for paying off your mortgage early, in addition to providing a better understanding of why you may, or may not, want to do so.

A quick recap on how mortgages work

A mortgage is a type of loan that individuals and families use to purchase their home. Most people want to own a home but don’t have the capital to pay for real estate with cash. To fill this gap, banks and other lending institutions front the money for the purchase of the home. The borrower (i.e., homeowner) then repays the loan under the terms of the mortgage.

Like other loans, the terms of a mortgage may vary depending on the lender, borrower, property and other factors. Generally, mortgage repayment structures have monthly payments consisting of principal (the amount originally borrowed) and interest (an additional charge owed for the privilege of borrowing money). The interest owed on a mortgage will depend on the applicable interest rate, either fixed or variable.

The term (i.e., length) of a loan is also generally fixed. Terms of 15 and 30 years are very common. Early in the term of a mortgage, monthly payments will largely consist of interest. The amount of interest you pay each month will decrease as more payments are made towards the loan principal. Once your mortgage is paid off (and assuming no other debts or liens exist on the property), your equity in the home more closely resembles its market value.

Why you may want to pay off your mortgage early

Several reasons exist why you may want to pay off your mortgage early. The overall value of these reasons may vary from person to person because of other financial obligations and goals. Furthermore, personal factors such as age, income and health may also impact the potential benefit of paying off a mortgage ahead of time.

To avoid paying interest

Over time, payments of interest from various loans (such as mortgages, auto loans and student loans) can greatly affect your personal wealth. Interest may seem like a small price to pay in the short term. However, each payment of interest takes part of your income and capital that you could use to accomplish other life and financial goals.

You can view the entire cost of mortgage interest by reviewing the total interest percentage (TIP) on your loan’s closing documents. Paying off your mortgage ahead of schedule may reduce the TIP you pay and save you money in the long term.

To increase household cash flow

Another reason you may pay off a mortgage early is to reap the reward of increased cash flow. For many households, their mortgage is the largest of their monthly expenses, which may limit opportunities for meeting other needs.

For those in the workforce, paying off a mortgage early can free up income for other purposes. You could use those extra funds to save for retirement more aggressively, travel, start a side hustle or pursue another life goal. Paying off a mortgage early can also reduce the financial burden on those with fixed income (e.g., retired persons who rely on savings, investment returns, Social Security or pensions).

To build equity in your home

Paying off a mortgage early also means increasing the equity in your home. Accountants and financial professionals will be quick to point out that owning a home is both an asset and a liability on your balance sheet. Your home is an asset so long as you have equity in it (i.e., the value of the property minus the outstanding balance on your mortgage is positive).

However, the mortgage on your property is also a liability – along with other potential costs associated with homeownership, like property taxes, maintenance and repair costs and homeowner association dues. Paying off a mortgage early reduces your liability on the property, which may provide flexibility later.

Ideas for how to pay off a mortgage early

No single best approach exists for paying off a mortgage early. Rather, several options may help you reach that end goal faster, depending on your finances and preferences.

Refinance to lower your interest rate

Lenders determine the interest rate for your mortgage by considering a few different factors. Refinancing your mortgage to obtain a lower interest rate can save you money in the short and long run by reducing your monthly payment along with the overall cost of your mortgage. Some of the factors that affect your interest rate are within your control, while others depend on external market conditions.

• Loan-to-value ratio: This is a measure of the amount of your mortgage compared to the home’s value. The size of your down payment will influence your loan-to-value ratio (the higher the down payment, the lower the ratio). A smaller loan-to-value ratio generally correlates to a lower interest rate.

• Your credit score: Credit scores look at your repayment history, current debts, and other factors to assess the risk of extending you credit. A higher credit score may translate to a lower interest rate.

• External market conditions: Lenders will look to broad economic metrics to help set their interest rates as a response to overall risk. Some of these metrics include employment rate, inflation and the Federal Reserve’s short-term interest rates, which tend to run parallel with mortgage rates.

Any substantial changes in these factors may present an opportunity to refinance your current mortgage with a more favorable interest rate. Refinancing a mortgage will usually involve additional fees and closing costs to process the transaction. It’s important to evaluate those costs with the savings from the new mortgage to determine your future break-even point and the overall value of the refinance.

Consider a mortgage recast

While refinancing involves obtaining a new loan with better terms, another option for paying off a mortgage early is a type of loan modification known as a mortgage recast. A mortgage recast is when you take a lump sum of cash and apply it to the principal of your loan. Your lender then resets your amortization schedule to reflect the new principal balance. The loan term and interest rate don’t change, but your monthly payment should decrease.

Compared to refinancing, a mortgage recast can be more affordable for homeowners with the available funds. The fees for mortgage recasting are often less than the fees for a mortgage refinance. If you have a high interest rate along with extra funds to apply to the principal, then a mortgage recast may make more sense.

Relocate to a more affordable home

You may also be able to pay off your mortgage early by selling your current home and buying a more affordable property. This may or may not be a realistic possibility depending on your circumstances (e.g., family size, remote work opportunities, etc.).

Different methods exist for determining how much housing a person can afford. Some analysts recommend not spending more than 30% of gross monthly income on housing costs. Another approach is the 28/36 rule, which suggests housing costs shouldn’t be more than 28% of your gross monthly income, and your total debt shouldn’t be more than 36% of gross income.

Buying a house within your financial means may give you the cushion to manage a 15-year mortgage instead of the more traditional 30-year mortgage. Depending on market conditions, you may also be able to sell your old home with added value from market equity. You could use that extra equity to increase your loan-to-value ratio on the next home, and thereby reduce your monthly payment.

Apply financial windfalls towards your mortgage

Avoid lifestyle creep by contributing financial windfalls to your mortgage, which can help you pay the loan off faster. Financial windfalls might include an inheritance or gift from a family member, or a bonus/salary increase from your work. Be careful when making additional lump-sum payments to your loan by specifying application of the funds to your principal, and not as a prepay of your next mortgage payment.

Key issues to consider before paying off a mortgage early

In isolation, paying off a mortgage early may seem like an obvious choice if you have the means to do it. However, financial decisions should not be made in isolation, and require a thorough evaluation of all relevant considerations. When it comes to your mortgage, some issues may exist that limit the overall benefit of paying it off early.

Look for prepayment penalties on your mortgage

Always read the fine print of your mortgage agreement before paying off the loan early. Seek help from a professional if you are confused about the terms. Many mortgages have terms that either prevent paying off a mortgage early or charge a penalty to do so. Lenders rely on the interest payments from your mortgage to turn a profit, and early repayment can reduce a lender’s profit margin. To recoup lost interest, lenders charge prepayment penalties.

Depending on your mortgage terms, this may make early payment less favorable. You can weigh the benefit of an early payoff when prepayment penalties exist by evaluating the penalty amount with the remaining TIP on the mortgage.

Possible loss of federal income tax deduction

Your federal and state income tax situation may also impact the actual value from paying off a mortgage early. An itemized deduction of mortgage interest exists for qualifying homeowners. In these cases – which are less common than before tax reform changes – paying off your mortgage early would negate the benefit of the possible deduction. Speak with an accountant to review your income and tax liability to see if paying off a mortgage makes sense.

Moving or selling the home

Paying off a mortgage in advance might not make sense if you have future plans that include selling your home. The reason is that paying off your mortgage early requires the transfer of liquid assets (cash) into a non-liquid asset (your home). The short-term benefit of increased cash flow from paying off the mortgage may not be worth the flexibility gained from holding on to your cash, especially if market conditions change for the worse and the value of your home decreases.

Reaching other financial goals

Finally, paying off a mortgage ahead of schedule may not be ideal if it means sacrificing or prolonging other financial goals. As mentioned above, placing extra cash into your house may limit your overall liquidity and financial flexibility for other pursuits. Some important financial goals that may have greater priority than an early mortgage payoff may include:

• Paying off debts with higher interest rates (e.g., credit card balances, student loans)

• Building an emergency fund

• Contributing to your 401(k), IRA or other retirement investment account

• Selected investment opportunities where potential returns may outweigh savings from paying off the mortgage

Learn about home equity agreements

Homeowners with home equity and who do not have the ability to pay off their mortgage early may find a home equity agreement valuable. A HEA allows homeowners to access the equity in their property by selling a percentage of their ownership interest in exchange for cash proceeds.

Contact Unlock today for questions about HEAs.