Paying Your Mortgage Off Quickly: What You Need To Know

Sun, Feb 16, 2014

Budgeting, Financial Advice

Making the decision to pay your mortgage off faster, or pay it in full early is a big deal. Surprisingly, it’s not always a sound financial move—it depends on the terms and conditions of your loan, and whether or not you have other debts. So what’s involved in paying the mortgage early, and when is it a good idea?

Why Pay Early?

Overwhelmingly, the main reason why people want to pay their mortgage off early is that it can save a huge amount of money in interest. Depending on the interest rate you’re paying on your mortgage, the amount you pay over the life of the loan can be twice as much—or even more—than the amount you actually borrowed.

Sometimes, a change in life circumstances is the deciding factor. A financial windfall such as an inheritance might provide enough cash to pay off a large amount of the mortgage, or a promotion or pay raise might mean it’s possible to make larger monthly payments. For some people it’s just personal preference—for example, it might be a matter of paying off the mortgage before retirement, or it might be about reducing the stress of having those payments to meet every month.

Another reason to make additional repayments is that it helps you build equity in your home faster. If you’re planning to move within the next few years that extra equity can help you negotiate a better deal on your next mortgage.

Options for Faster Payment

Early repayment options include more than just paying off the entire balance of the loan—you can also opt to make larger repayments, or make additional payments in addition to scheduled ones.

One popular option that helps you pay the mortgage off a little faster without substantially increasing the size of your monthly payments is to make your payments biweekly instead of monthly. In terms of amount, the biweekly payment is approximately half of what you’d pay if you were making monthly payments, so there’s very little difference in what you pay from month to month. However, by making 26 biweekly rather than 12 monthly payments, you essentially make one extra payment a year. It’s not much, but it’s enough to help you pay the mortgage off a little faster, and therefore pay less interest overall. Depending on your lender this option might incur an extra fee, since it results in slightly less profit for them, and requires slightly more administration time.

Another option is to overpay the principal on your mortgage total. This means you make your regular monthly (or biweekly) payment, and pay extra money at the same time, with the extra going directly to pay off the principal. If your lender allows you this flexibility, you can overpay by a set amount every month, or just pay whatever you can afford from month to month. Again depending on the flexibility of your mortgage, you can simply opt to pay extra any time you can afford it, instead of making extra payments on a schedule. This can work well for people who have unpredictable levels of disposable income, such as freelancers and small business owners. Either way, it’s important to make a specific arrangement with your lender to do this, to make sure that the extra money you’re paying does go to paying off the principal. The advantage to this method is that since you’re putting the extra money towards paying the principal, it’ll reduce the amount of interest you pay over time.

It’s particularly advantageous to make extra payments when you first get the mortgage, because your payments are frontloaded with interest—you pay off very little of the principal during the first few years, so putting extra money towards the principal at this time is very beneficial. It’s worth repeating that the success of making additional payments requires that the money goes towards paying the principal, and not the interest, so there’s no point in paying extra unless you know for certain that it’s paying principal. Any extra money that goes towards interest is essentially wasted, because paying interest doesn’t reduce how much you owe.

Refinancing

Most people think of refinancing in terms of reducing the size of their mortgage repayments, but refinancing is also a means of repaying the full amount earlier.

There are two main possibilities where refinancing can help you achieve this. First, if interest rates drop, you might be able to refinance your mortgage to reduce the term of your loan, but keep your repayments approximately the same. The second possibility is that if your financial situation improves and you can afford to make larger repayments, refinancing might reduce the term of the mortgage. Deciding whether it’s time to refinance can be difficult, because the effectiveness of refinancing depends on several things—your current mortgage interest rate, the rate you could obtain by refinancing, the additional amount you have for repayments, and the potential return if you saved or invested the extra money instead. Many countries, including the US and the UK, have held interest rates down in an attempt to help people and the economy recover from the recent financial downturn. This means it’s a useful time to prepare for refinancing, since any mortgage calculations you make now will be viable for a good twelve months or so, making it easier to plan a budget. Lender interest rates still do fluctuate, but while reserve rates are capped, it’s somewhat easier to predict. Another point to consider is how much equity you have in your home, since the more equity you have, the more leverage you have to negotiate favorable mortgage terms. In both theUK and theUS, for example, house prices have increased over the past couple of years, which means that many families have less proportionately equity in their homes than they would have, had the market not improved.

It’s important to think about refinancing carefully for another reason: the administration costs can total up to 5% of your outstanding principal, so you have to be sure that the costs of refinancing won’t outweigh the amount you stand to save. As well as this, think about whether refinancing will be a better option than just paying more money each month on your current mortgage.

Early Payment in Full

If a financial windfall makes it possible for you to repay your mortgage in full, it’s a great opportunity, but it’s important to think carefully about the timing, simply because early repayment can have a hefty penalty attached. Early payment penalties exist because paying in full means the lender makes less money in interest payments. The first few years of a mortgage are when most of the interest gets paid, so lenders can lose a lot of their profit if the loan is fully paid during this time.

These penalties are much less common than they used to be, and in fact no federally-backed loan schemes have early payment penalties. These days most loans with such penalties are commercial loans and investment property mortgages. For residential mortgages that have early payment penalties, the penalty period is typically less than five years.

Sometimes It’s Better to Delay an Early Repayment

Most of the time, early mortgage repayment is a great financial option, but there are some situations in which it’s better to wait.

  • If you want to pay in full, but the amount you’ll owe in early repayment fees is greater than the amount you’ll save with an early repayment, wait and invest the money or bank it instead.
  • If you have other debts with a higher interest rate than the mortgage, pay those other debts off first.
  • If there’s a chance that you might need the money in the near future, hold onto it instead of putting it on the mortgage—instead, just let it accrue interest in a savings account.

 

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