Wondering if the income needed to buy a home in the top 50 metro areas is starting to decline? Hint: Not yet.

Wondering if the income needed to buy a home in the top 50 metro areas is starting to decline? Hint: Not yet.

Should I pay off a mortgage early?

Keith Gumbinger

Owning a home free and clear has often been a financial goal for homeowners. For some, this may be a distant dream; for others, a challenge to be free of a mountain of debt, removing the risk of losing one's home to a bank foreclosure.

There are a number of ways to approach the process of becoming mortgage free as quickly as possible, but these may come with a degree of risk, too, not the least of which may be opportunity risk, where money plowed into your mortgage might actually be put to better and more productive use elsewhere.

The Cost of a 30-Year Mortgage

Over a 30-year period, the interest you pay on your mortgage will far exceed the amount you borrowed. On a $300,000, 30-year loan at 4.5%, you would pay $247,218 in interest for a combined total of $547,218 in payments. If you take out the same loan balance over 15 years at 3.75% (15-year mortgages typically come with rates about 0.75% lower than 30-year loans), your interest expense over the life of the loan drops to just $92,700. Refinancing to a 15-year mortgage would accelerate your mortgage payoff and could also help you get a lower mortgage rate. However, as beneficial as a shorter-term mortgage may be, a shorter repayment term means that your required monthly payment will be higher -- in this case, about 44% higher. Thank can make a shorter-term loan unaffordable, especially in the early years of a mortgage when the loan balance is at its highest.

Methods for Accelerating Your Mortgage Payoff

While some companies sell early payoff services (often in the form of biweekly payment handling), there have been any number of warnings over time about some dubious companies that just take your payments and disappear. Even legitimate companies aren't offering you any service that you can't provide yourself, so there's no need to take your chances. Here are several strategies for retiring your mortgage early.

Make bi-weekly payments. You can do this yourself by transferring half a month's mortgage payment every two weeks into a checking or savings account (preferably interest-bearing). If a bi-weekly payment plan is available from the lender or servicer, they will draw funds every two weeks from this account via automatic debit.

Some lenders or loan servicers will set up a bi-weekly payment plan for you for just a small one-time fee, but there may be small recurring transaction fees, too. As well, you may be required to keep an additional mortgage payment or two in that account so that there will always be sufficient funds available to make a half-payment.

Since there are 26 two-week periods in a year, you end up making the equivalent of one extra payment per year. If your lender or servicer doesn't offer a bi-weekly payment plan, you can achieve nearly identical savings by simply sending in one extra payment -- a 13th monthly payment -- every year.

Make extra principal payments. Another method is to look at your amortization schedule to see how much of your payment is allocated to interest, and how much goes toward paying down the principal. You can do this easily by plugging your loan terms into HSH's mortgage calculator.

When you do, you'll notice that in the beginning of your loan, your payments are almost all interest. Over time, the amount of your monthly payment that goes toward interest decreases, while the amount that goes toward principal increases. If you have the means, you can even pay the loan off in half the time by doubling your principal payment each month; however, if you could afford such a high payment (and can commit to making it over a long stretch of time) you would likely be better off refinancing to a 15-year loan at the same or lower interest rate (if it is available to you).

You don't need to make large regular prepayments to achieve real interest savings over time, and any size prepayment will help to shorten your term and save interest. Even as little as a few dollars of prepayment per month can cut a couple of months off your loan and save several thousand dollars in interest over time. A painless way to make small prepayments is to simply round up your payment to the next $5 or $10 increment. To see the savings from this prepayment method, use HSH's RoundUp Prepayment Calculator.

Refinance to a shorter term. This is the only method that can get you a lower interest rate. By refinancing to a 15-year mortgage, you are eligible for a lower mortgage rate, typically a half point or more lower than a comparable 30-year mortgage rate.

PreFi. If mortgage rates aren't low enough to make refinancing desirable, or if you can't or don't want to refinance, prepaying your mortgage can bring savings equivalent to refinancing without the cost or hassle of getting a new loan. HSH's "Prepayment is Equivalent to Refinancing" Prepayment::Refinance (PreFi) calculator will do the math for you, whether you're sending in an additional $1 or $100. You decide how much to prepay, and the calculator will show you the effective interest rate you'll create for your loan and the savings it will produce.

You can even decide what effective interest rate you would like your loan to be: Use HSH's LowerRate Prepayment Calculator to find out how much prepayment you'll need to make to achieve the rate you want.

Drawbacks to Paying Off Your Mortgage Early

It's important to also be aware of the drawbacks associated with paying off your mortgage early.

Opportunity cost. By directing extra funds to paying off your mortgage early, you forgo the opportunity to earn money on investments with higher returns than the amount of interest being paid on your mortgage. Historically, equities have averaged returns somewhere in the neighborhood of 10% per year. While stocks can be a risky investment, they stand the chance to earn a lot more over the long term.

Loss of liquidity. In turbulent economic times, loss of cash is a strong consideration. Banks only like to lend money when you don't need it. And if you have been socking your extra money away into your mortgage and you suffer a financial setback, you may have a hard time getting access to that money. At best, you'll have to apply and pay for a home equity loan, which carries costs, interest expense and inconvenience; at worst, you won't be able to get a loan and may end up having to sell your home.

The Right Way to Pay Off Your Mortgage Early

Refinancing to a lower rate and a shorter term can be a good decision, if you can afford it. If you have already been paying down a 30-year mortgage for several years and stand to get a lower mortgage rate in a refinance, a 15-year 20-year mortgage payment might not be that much more than your current payment, or could even be less, given the right combination of lower rate and remaining balance on your existing loan.

Before you start your plan, you should probably take care of a little financial housekeeping first.

Build up an emergency fund. Experts recommend saving 3 to 9 months worth of expenses in case you're laid off, injured, or something else happens that makes you unable to work.

Pay off high-interest debt. High-interest credit cards can cost you a lot more in interest than your mortgage, and they confer no tax advantages.

There are a lot of things to consider before you make the decision to start prepaying your mortgage, ranging from the best methods for your situation, alternate or better uses for prepayment funds and more. Before you start to make any mortgage prepayments, you'll want to review HSH's comprehensive Mortgage Prepayment Guide, where we cover everything you'll need to know about terminating your mortgage early.

Ask the expert
Keith Gumbinger
Keith Gumbinger
Mortgage Expert
Vice President, HSH.com
About Keith: Mortgage market observer and analyst with 35 years experience... (more)
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