Buying a home is probably the biggest purchase you will ever make in your life. It’s often described as the fulfillment of the American Dream. And, indeed what a wonderful thing it is…especially if you own your home with NO MORTGAGE hanging over your head!
Two reasons that I hear some people give for not paying off your mortgage is (1) You lose the mortgage interest tax deduction, and (2) You should invest all you can instead of paying off your mortgage. So, before I give you my quick tips to pay off your mortgage early, let me address these two claims.
It is true that paying interest on your mortgage reduces your tax obligation. But only by your tax rate. So, if your tax rate is 20%, then you still lose 80% of your interest. If you repeatedly make decisions to pay Person A $1,000 in order to ensure Person B pays you $200, you will eventually go broke. Similarly, I don’t see the logic behind wanting to pay your bank $1,000 in interest in order to ensure the federal government pays you $200 at tax time. PLEASE don’t maintain a mortgage in order to maintain your tax deduction. The math is a LOSER on this trade!
So how about the argument about maintaining a mortgage so you can pour all you can into investments? Unlike the tax deduction argument, that we just debunked, at least a logical argument can be made for this one.
Here’s how I think you should approach this decision. Paying off your mortgage in essence has a known guaranteed rate of return. If your mortgage rate is 3% that means that any investment you make must have a better return than 3% in order for it to be a better financial decision. Right now, that means investing in the stock market which over time should indeed outperform 3%. However, some years will be 20% and some will be negative 20%. So, to accept this volatility of returns (“risk”) you should demand a return greater than your guaranteed rate of 3%. How much higher is up to you and your own risk tolerance. For me…I wanted to be debt free and took the guaranteed rate of return by paying off the mortgage early.
This did not mean however, that I stopped putting money into my retirement funds. If you are choosing between the two, then keep investing for the future and making your scheduled mortgage payments. This article is for those who have extra cash to invest and are considering whether to and how to go about paying off their mortgage early.
So, if you too are considering paying off your mortgage early first check with your lender to make sure your mortgage allows prepayments without penalty and that the prepayments will be applied to principal rather than the next month’s mortgage payment. If additional payments will be applied to principal without penalty, here are some pain free tips to pay-off your mortgage.
Applying additional money toward the principle on your mortgage will save you no matter when you decide to do it, but starting early on will have the biggest impact. As each month goes by, a larger portion of your payment goes toward principle. So, during the first year of a mortgage, most of your payment goes toward interest. During the last year, most of your payment goes toward principle.
Things to do before paying off your mortgage early
- Pay-off all other debt (credit cards, car loans, student loans)
- Create an emergency savings fund (non-retirement) equal to at least 3 months of expenses
- Have sufficient life insurance for your situation
- Appropriately invest toward retirement (typically somewhere between 8-12% of gross income)
3 Quick Tips to Pay Off Your Mortgage Early!
Let’s create an example situation so that we can analyze the financial benefit of each tip. Maria just bought a house for $375,000 and put 20% ($75,000) down taking out a 30-year mortgage for $300,000 at 3.50%
Tip #1 – Refinance to a lower rate but keep making the same payments.
Mortgage rates having been going down for many years and are at historic lows. And many people have already refinanced their mortgage multiple times. Great! But as you do this have you continued to make the same payment or have you just dropped your payment as your new lower rate has allowed?
If Maria could refinance her rate from 3.50% to 3.00% but keep making the same monthly payment, she would shave 2 years 10 months off her mortgage.
Tip #2 – Increase your mortgage payments as your income increases
Maria’s mortgage payment is 25% of her gross income. She just got a 4% raise. If she keeps her payment at 25% of her new higher income, she is now contributing more toward the principle on her mortgage. Doing this once knocks 2 years off her mortgage. If she gets a 4% raise every year and consistently keeps applying 25% of her raise toward her mortgage, she would pay her mortgage off 3 years early!
Tip #3 – Make a payment every two weeks instead of monthly
Making half a payment every two weeks results in 26 payments or 13 months of payments in a year. This is one extra monthly payment per year. Or if your lender doesn’t allow that then make an additional month’s payment once per year. If Maria did this, she would knock 4 years off her mortgage.
Try combining two or all three of these tips and become DEBT FREE 7-10 years early!