Homeowners with low mortgage rates have an easier time paying off their mortgage early. But is that a good idea? It’s not a “yes” or “no” question.
You might be better off putting extra money in a Roth IRA or 401(k) than paying off your mortgage ahead of schedule. And if you’re applying for need-based education aid for your kids, a paid-off mortgage or a lot of home equity can count against you at colleges where equity is considered money in the bank.
If, after considering the potential downsides, you still want to pay off your mortgage early, here are four ways to make it happen.
- Refinance with a shorter-term mortgage.
- Pay a little more each month.
- Make an extra mortgage payment every year.
- Throw all “found” money at the mortgage.
1. Refinance to a shorter-term mortgage
You can pay off the mortgage in a shorter term by refinancing into a 10- or 15-year mortgage.
Let’s say you got a 30-year fixed-rate mortgage for $200,000 at 4.5 percent. Five years later, you refinance into a 15-year loan at 4 percent. Doing so pays off the mortgage 10 years earlier and saves you more than $60,000 (if you exclude closing costs on the refi).
Shorter-term mortgages usually have interest rates a quarter to three-quarters of a percentage point lower than 30-year mortgages.
But a refinance carries closing costs. And a quicker payoff means higher monthly payments. You’re locked in if you decide that you don’t have the extra money one month to put toward the mortgage.
Unless the new interest rate is lower than the old rate, there’s no point in refinancing.
2. Pay a little more each month
You can get all the benefits of an early payoff without the extra costs of a refinance by paying more each month.
Divide your monthly principal and interest by 12 and add that amount to your monthly payment for a year. Result: You make the equivalent of 13 payments in 12 months.
Let’s say you got a $200,000 mortgage at 4.5 percent. After five years of making the minimum payments, you add an extra 1/12 of a month’s principal and interest to each monthly payment. Doing so pays off the mortgage three years and three months earlier and saves more than $18,000 interest.
Before you make anything beyond the regular payment, call your mortgage servicer and find out exactly what you need to do so that your extra payments will be correctly applied to your loan.
Let them know you want to pay more aggressively and ask the best ways to do that.
Some servicers may require a note on the notation line of the check about how to apply the extra money.
Always check the next statement to make sure your payment has been applied properly.
3. Make one extra mortgage payment each year
Instead of paying a little more each month, make one extra monthly payment each year. One way to do this is to save 1/12 of a payment every month, and then make an extra payment after every 12 months.
Let’s say you do this starting the first month after getting a 30-year mortgage for $200,000 at 4.5 percent. That would save more than $27,000 interest, and you would pay off the mortgage four years and three months earlier.
4. Apply ‘found’ money toward the mortgage
Let’s say you got a 30-year fixed-rate mortgage for $200,000 at 4.5 percent. Then, five years later, you can pay an extra $10,000 in a lump sum. Doing so pays off the mortgage two years and four months earlier, and saves more than $19,000 in interest.
The downside to this approach is that it’s hard to predict the mortgage payoff date. And be careful of putting so much extra cash toward the mortgage that you come up short for other needs.