Laura answers a listener's question about whether to pay off a mortgage early and how to do it.
Laura answers a listener's question about whether to pay off a mortgage early and how to do it.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Jenni:
"I'm a 52-year-old single mom, and my finances are in good shape. I want to pay off my home so I'll be completely debt-free when I retire. What do you think about paying off a mortgage early, and what's the best way to do it?"
Thanks for your question, Jenni! For most homeowners, having a mortgage payment is their largest debt; getting rid of it would feel terrific. While being mortgage-free is an excellent goal, it may not always be the best use of your money.
If you're a homeowner or want to be one someday, this post will review the pros and cons of paying extra on your home loan. I'll review when it's wise to pay off a mortgage early and eight strategies for eliminating it faster when it's the right move for you.
Welcome back, everyone, and thanks for joining me on episode 857! I'm Laura Adams, an award-winning author, finance spokesperson, money speaker, founder of The Money Stack newsletter, and host of the Money Girl podcast with 43 million downloads.
My mission is to help you get the knowledge and motivation to prioritize your finances, build wealth, and have more security and less stress. Every episode is a mini-money training designed to help you take your financial life to the next level.
If you're getting value from the free content we love creating, consider submitting a 5-star rating or review on Apple Podcasts, Spotify, or wherever you're listening! If you have a question you'd like me to cover, please leave it on our voicemail line at 302-364-0308. You can also send an email and sign up for the free Money Stack newsletter at LauraDAdams.com.
ALSO READ: How do you know if you can retire early?
What are the downsides of paying off a mortgage early?
Let's start by reviewing the downsides of paying off a mortgage early. I mentioned that there are better moves for some homeowners. That's because, in the big picture of your finances, a mortgage should be low on your debt priority list, even though they're typically your largest debt.
It's important to remember that a mortgage is a relatively inexpensive debt with tax benefits, which can make it cost even less on an after-tax basis.
The going rate for a 30-year, fixed-rate mortgage is about 6.5% right now. But if you claim the mortgage interest tax deduction by itemizing it on your tax return instead of the standard deduction, that could reduce your actual mortgage rate by about a percentage.
However, recent tax law changes have made the mortgage interest deduction less advantageous for many homeowners, who come out ahead claiming the standard deduction instead.
Whether you can deduct a portion of your mortgage interest or not, once you send extra money to a home lender, it's tied up in your property. Additionally, sending extra money to pay a mortgage early means you lose the opportunity to invest for higher returns.
For instance, buying an index fund in a Roth IRA that pays an average 8% annual return is better than paying extra on a mortgage that costs you 6% or much less.
While mortgage rates have increased in the past couple of years, if you bought a home before the pandemic, you could have a rate under 3%. That's a fantastic opportunity to use your extra money to generate higher returns.
While getting rid of any debt is ultimately good for your finances, paying it off in the correct order is essential. So, always consider your mortgage in the context of your entire financial situation.
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What are the benefits of paying off a mortgage early?
The primary advantage of paying off a mortgage (or any debt) ahead of schedule is paying less interest. For example, if you owe $300,000 on a 30-year, fixed-rate mortgage at 5%, your monthly payment for principal and interest would be about $1,600.
If you keep the home for 30 years, your total payments would be more than $578,000. Your interest portion of the payments would be about $278,000–a hefty price! Paying off a mortgage ahead of schedule means you reduce the total interest you pay on the life of the loan and shorten your repayment term.
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Should I pay off my mortgage early?
While the upsides of sending extra money to your mortgage can be tempting, first evaluate your financial situation. Jenni said her finances are in good shape but didn't give any details.
Jenni, I'd like to know how much you have in emergency savings and whether you're regularly investing for retirement with a sufficient balance based on your goals. If you don't have a healthy emergency fund, aren't investing at least 10% of your gross income for retirement, or have high-interest debt, sending extra to a mortgage is not wise.
You'd be much better off using your extra money to build a cash cushion, eliminate any expensive debt, and invest for retirement before paying off your home ahead of schedule.
But if Jenni has emergency funds equal to at least three months' worth of living expenses, invests 10% to 15% for retirement, and has no other debt, reducing her mortgage may be an excellent financial move.
8 strategies for paying off a mortgage early
If paying down your mortgage early is suitable for you, here are eight strategies to consider based on how aggressive you want to be.
1. Pay an extra dollar.
If you don't have much extra money to send to your home lender but expect your income to increase over time, you could increase your monthly payment by one dollar.
For instance, if you have a $150,000, 30-year fixed-rate mortgage at 6%, your first monthly payment would be $900. You could pay $901 for the second month, $902 for the third month, and so on. That schedule would cut about eight years off your repayment term and save thousands of dollars in interest.
2. Make bi-weekly payments.
Sending biweekly payments means you send half your payment every other week instead of making one monthly payment. It allows you to make an extra monthly payment each year because there are 13 weeks in each quarter, not 12, and 52 weeks in a year, not 48.
Suppose you have a 30-year mortgage for $160,000 at 6.5% interest. The payment is $1,000 per month or $12,000 per year. If you keep that payment schedule, you'll pay about $202,000 in interest over the life of the loan.
But if you make biweekly payments instead, you'd pay half the monthly payment, or $500, every other week. You'd end up paying $13,000 in payments instead of $12,000.
Sticking to a biweekly schedule would cut your interest from about $202,000 to $184,000, saving $18,000 over the entire loan. You'd also pay off the loan in about 27 years instead of 30. You can use a Biweekly Mortgage Calculator to see your savings.
The problem is that some lenders don't apply early payments to your principal balance and may hold it in an escrow account until they receive your full payment. If that's the case, making biweekly payments won't help you.
So check with your lender about the best way to make biweekly payments. If they try to make it complicated or charge a fee, I recommend using another payoff strategy covered here.
3. Send an extra full payment each year.
If you can't get a mortgage lender to apply biweekly payments to your principal as you send them, make one extra payment a year that gets fully applied to your balance.
Let's say your monthly mortgage payment is $1,200. Make a goal to save that much by putting $100 monthly in a dedicated savings account. At the end of the year, you'll have an extra payment saved to send to your lender.
Again, make it clear that you want the entire amount applied to your principal loan balance by entering "apply to principal" in the memo section of your payment. Or make the payment through your online mortgage account, where it may be easier to indicate that you want the extra amount applied to your principal balance.
4. Include an extra flat amount monthly.
If you're determined to pay down your mortgage early, you might budget an additional flat amount to pay each month. Let's say you have a $100,000, 30-year, fixed-rate mortgage at 4.5%. If you add an extra $100 to your monthly payment, you'd pay it off almost nine years earlier and save over $26,000 in interest.
You could also round up your monthly payments. For instance, if your payment is $970, you could consistently pay $1,000 instead. Enter your mortgage information in a Mortgage Payoff Calculator to determine how much you'd save in different scenarios.
5. Send your windfalls.
While you can pay off your mortgage slowly and steadily by regularly paying the same amount each month, you don't have to be consistent. There's nothing wrong with sending one big payment when you can.
For instance, If you get a bonus at work, a tax refund, or an inheritance, you can send it to your mortgage and then return to making regular payments. Again, be clear with your lender that you want the extra to pay down your principal balance, not to get credited toward future interest payments.
ALSO READ: How to launch a windfall into wealth
6. Set a target payoff date.
If you have a specific date in mind that you want to be mortgage-free, such as when you retire, figure out how much extra it will take. Since the math gets complicated, use a Mortgage Payoff Calculator to enter different amounts of extra payments until the final payoff date is close to your target.
7. Eliminate private mortgage insurance (PMI).
Private mortgage insurance is charged by lenders when your down payment on a conventional home loan is less than 20%. However, once you pay down your mortgage to 80% of the original value, you can request a PMI cancellation. You could use that savings to pay off your mortgage faster.
For instance, If you have a 30-year fixed-rate loan for $180,000, the PMI could be close to $100 monthly. Getting rid of that premium frees up $100 to send to your mortgage principal instead.
8. Refinance your mortgage.
Refinancing a mortgage is when you get a new mortgage that pays off and replaces your existing one. The new loan can be with your same institution or with a different lender.
For example, if you have a fixed-rate mortgage at 7.5%, you could refinance with a 30-year mortgage at 6%. That would reduce your monthly payments and the amount of interest you pay over the life of the loan.
The best situation for a refinance is when you have at least 20% home equity and pay at least 0.75% more than the going mortgage rate, which is about 6.5% as of late August 2024.
Suppose you have a $300,000 fixed-rate mortgage at 7.8% and can refinance to a 6.5% loan. That rate reduction could cut your monthly payment by about $260, saving nearly $95,000 in interest over 30 years. You could also refinance to a 15-year mortgage, increasing your monthly payment but saving even more interest over the life of the loan.
But you must do your homework and understand what a refinance will cost. The total fees could range from 2% to 6% of the loan amount, depending on where you live and your lender. You must be sure you'll own your home long enough to recoup those expenses, passing a break-even point.
If you don't own your home long enough to save money on a refinance, accounting for its costs, it's not a good idea. It will never be wise for homeowners who enjoy mortgage rates significantly lower than today's going rate.
To sum up, paying off your mortgage early is only wise if you have rock-solid finances with plenty of emergency savings, regular retirement contributions, and no debt other than your mortgage. Instead, use your extra cash to strengthen your financial foundation and earn higher returns than you'd get by sending it to your home lender.
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That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
Money Girl is a Quick and Dirty Tips podcast, and I want to thank our fantastic team! Steve Riekeberg audio-engineers the show. Brannan Goetschius is our director of podcasts, Holly Hutchings is our digital operations specialist, Morgan Christianson is our advertising operations specialist, and Davina Tomlin is our marketing and publicity associate.