Many people have a dream of paying off the mortgage on their home. A house payment is the biggest expense for most people and not having a house payment would seem to provide security. There are many things home owners need to know about paying off their mortgage and how it will affect them financially. While it seems like a great way to reduce a huge payment, does it make sense to pay off the loan early? Some things to consider are how much money you are saving, what your interest rate is, how long it will take to pay off the mortgage, and what would happen if you find yourself in a bind and need to access money from your home.
How long does it take to pay off a mortgage?
Different mortgages have different loan terms. The most common mortgage has a 30 year term, but some mortgages can be 15 years, 10 years or even 5 years. When you get a mortgage with a 30 year term, the loan will be paid off in 30 years if you make the minimum payments every month. Here is a great article that shows what your payment would be on a $200,000 house and how different interest rates effect that payment.
If you took out a $200,000 loan at a 4 percent interest rate on a 30 year mortgage, the payment would be about $955 (does not include taxes and insurance). What scares people is that over those 30 years, the borrower would be paying over $143,000 in interest on the loan. That is almost as much money in interest as the loan itself! If a borrower decided to pay off the loan early by making $100 more in payments every month, they would reduce the interest paid down to $116,000 and reduce the loan term to 25 years instead of 30. That seems like a smart financial move on the surface, but lets look at what else a homeowner needs to consider before paying off a loan.
Are you able to save money aside from paying extra towards your mortgage?
I think the first thing a homeowner should look at before paying off their mortgage, is how much money they currently save. Everyone should have an emergency fund, which may be 6 months of living expenses. An emergency fund is there in case someone gets hurt or loses their job. If you cannot save any money and live paycheck to paycheck, I would focus on saving money before you spend anything extra on your mortgage.
Accessing the equity in your home is not easy (equity is the difference between what you owe on your house and what it is worth). If you plan to save money by paying off your mortgage, you will have to refinance your home, sell it, or get a line of credit against the house. The tricky part about getting a line of credit or refinancing your home is you have to qualify for a new loan. If you have lost your job, or are in a bad spot financially, it can be very tough to qualify, even if you have a lot of equity. For many people who need to access the money in their home, the only option is to sell. However, when you sell your house, you have to pay real estate agents and many other costs that could be as much as 10 percent of the sale price. You also have to find a new place to rent, and go through the hassle of moving. Your home should not be used as a savings account and if you cannot save money now, I would not pay off your mortgage early.
How much money do you save by paying off your mortgage early?
If you have an emergency fund and are saving money, you may want to consider paying off your mortgage early. Some things to consider are do you have any current investments and what return are you getting on those investments? Most home mortgages have less than 5 percent interest rate and many less than a 4 percent interest rate. If you pay off your mortgage early, you are basically making whatever your mortgage interest rate is on your investment.
The difference between paying off a loan and investing that money in something that earns interest is that you will not see any gain from paying off the loan until you pay off your entire mortgage. If you were making 5 percent interest in another investment, you would make 5 percent on any money you invest as soon as you invest it. However, paying off a mortgage early will not make any money unless you sell, refinance, or fully pay off the loan. If you have a $200,000 mortgage and your payment is $954 a month. You could pay that entire mortgage down to $5,000, but your payment would still be $954 a month. The payment will not decrease or change until you pay the loan completely off. Even though you are gaining equity and net worth on paper, when you pay extra towards your mortgage you won’t see an actual gain until the loan is completely paid off.
It is true that making extra payments will reduce the total interest you pay. If you make $100 of extra payments every month, you will pay off the loan 5 years sooner and pay $27,000 less in interest on the loan. $27,000 is a lot of money, but that is only $900 a year over 30 years. If you are making $100 in extra payments every month, that is $1,200 a year you are paying that you could be saving or investing in something else. If you invest that $100 a month into something that made 5 percent interest every year for 30 years, you would have $59,554.45 saved after 25 years (the same time you would have paid off the loan).
Most people will make more money and be more secure saving and investing, instead of paying off their loan early. It is much easier to tap into a savings account if you lose your job or get hurt than to tap into the equity of your home.
There are some loans that will allow a loan recast. With a loan recast you may be able to lower your payment based on how much you have paid off your loan. The loan recast is not available with all loans and does not shorten the length of the loan.
What is mortgage insurance and how would it change based on paying down a loan early?
There are many mortgages available for first time buyers like FHA, VA or conventional programs. One advantage to paying off a mortgage early is being able to remove mortgage insurance. Mortgage insurance is required on most loans where the buyer is putting less than 20 percent down. Mortgage insurance can add hundreds of dollars a month to the monthly payment and protects the lender in case the borrower defaults. FHA mortgage insurance will always be on the loan, but some conventional loans have removable mortgage insurance. After a few years, if the loan amount is less than 80 percent of the value of the home, the mortgage insurance can be removed.
If a home owner does not think they will have enough equity built up to remove their mortgage insurance through regular payments, it may make sense to pay extra towards the loan. Once the loan amount reaches 80 percent or 75 percent (whatever the lender requires) of the value of the home and enough time has passed, the borrower can ask the lender to remove the insurance. The lender values the home and may remove the mortgage insurance at that point. Removing the mortgage insurance on a property is one case where the homeowner will see a lower payment by paying off their mortgage early before it is completely paid off.
Should you pay off other debt first before paying off a mortgage?
Most mortgages are 30 year loans, which means the lender cannot call the loan due for 30 years. The payment most likely will not change much, unless taxes or insurance go up on your home, or you get an adjustable rate loan. Because mortgages have low rates and long terms, I think they are great loans. Most student debt, car loans, credit cards and other loans have shorter terms, higher rates, and higher payments. I would concentrate on paying other debt off before you pay off the mortgage on a home. It is also a lot easier and cheaper to sell a car than it is to sell a house if you need the money. With credit card debt, the more you pay off, the less your payment is, meaning you see an immediate benefit.
What are the benefits of paying a mortgage off early?
Some borrowers have peace of mind that they have no debt. However, debt is not always bad thing. I would rather have a large sum of money saved or invested and some debt, than no debt and no money saved up. When people get into financial trouble, it is not easy to access the equity in a home. It is much easier to access cash from other investments or a savings account. There are some cases where paying off a mortgage makes sense.
- Some people may not be disciplined enough to save money in an account without spending it. If that is the case, maybe it makes sense to pay off your mortgage early as a way of forcing yourself to save.
- When you pay off debt it can reduce your debt to income ratio, making it easier to qualify for a new house or car. Debt to income ratio is based on of the monthly payments, not the total amount of debt. Paying down the debt will not help your debt to income ratio until you pay off the entire amount and no longer have a payment.
- Reducing payments by removing mortgage insurance. We already talked about this strategy earlier.
- Paying down loans can make your net worth higher (assuming you are not saving that money).
- If you pay down your debt and the real estate market decreases, you may be able to sell your house easier. Again, if you would have saved that money in an account somewhere, you could still sell your house and bring some of the saved money to closing.
There are advantages to paying off your mortgage, but most of them come to those who cannot save money on their own. There are many people who if they have money, they will spend it. If you can’t make yourself save money, maybe paying off a mortgage is a good way to build a nest egg, but it will be hard to get to and will not have many advantages until the loan is completely paid off.