With the Income You Need to Buy a Median-Priced Home rising, you may need to Learn About Adjustable Rate Mortgages to preserve affordability.

With the Income You Need to Buy a Median-Priced Home rising, you may need to Learn About Adjustable Rate Mortgages to preserve affordability.

Should I pay off a mortgage early?

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 and one that removes the risk of losing a home to a bank foreclosure.

There are a number of ways to approach the process of becoming mortgage free, but these can all 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 too. Of course, a shorter term means that your required monthly payment will be higher -- in this case, about 44% higher.

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.

Pay every two weeks. 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). Pay your mortgage from that account once a month; the lender will usually require that the payment be automatically debited. Some lenders will set this up for you for just a small fee.

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. You'll notice that in the beginning, 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. You can pay the loan off in half the time by doubling your principal payment each month. The advantage of this method is that your payment increases gradually over time -- as hopefully your income does as well. Since this is can be a costly strategy, it's worth noting that any size prepayment will help to shorten your term. Even $5 extra each month will cut a couple of months off your loan and save several thousand dollars in interest.

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.

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 other considerations before embarking on an early payoff trek, you should consider both the risks and benefits to determine if doing so is the right choice for you.

Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte. HSH.com vice president Keith Gumbinger also contributed to this article.

  It's My Term mortgage prepayment calculator
  HSH's comprehensive Mortgage Prepayment Guide
  Mortgage payoff calculator

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Keith Gumbinger
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