No matter how much we dislike debt, most people achieve home ownership with the help of a mortgage. While it may be necessary to get your foot in the home ownership door, paying off a mortgage as soon as possible has many financial benefits, including saving thousands of dollars in interest payments.
If you want to pay down your mortgage faster, start by reviewing your papers and noting whether there is a mortgage prepayment penalty. If so, identify in which cases you have to pay it and how it is calculated.
Beware of Prepayment Penalties
Homeowners without prepayment penalty mortgages can make extra payments whenever they like at no cost. However, prepayment penalty mortgagors face restrictions. Prepayment options are governed by the terms and conditions of your mortgage, and can vary significantly between mortgages and lenders.
Search your mortgage documents for the phrases “prepayment disclosure,” “prepayment penalty disclosure,” or “prepayment penalty.” Review the terms carefully before making any extra payments to ensure that you aren’t charged extra for doing so. Mortgages with prepayment penalties are offered on 15-, 20-, 30-, and 40-year fixed-rate mortgages and adjustable-rate mortgages, and the prepayment penalty is often in place for up to the first five years of the mortgage.
Prepayment penalty mortgages may allow borrowers to pay anywhere from 10% to 20% off the mortgage principal annually without penalty by using a principal pay-off allowance. However, a penalty is charged for payments exceeding this limit.
The actual penalty is calculated in a variety of ways depending on the lender and the terms of your particular mortgage. One mortgage may charge 2% of the outstanding mortgage amount, while another charges six months interest. When you make extra payments on your mortgage, the mortgage company isn’t going to earn as much interest as expected so they charge the penalty to try to recoup some of the loss.
Benefits of Paying Off Your Mortgage Early
There are several benefits to paying your mortgage off early:
- It reduces the total interest paid
- It reduces the number of years your money is committed to paying off debt, therefore increasing the number of years your money can be directed to other things, such as saving for retirement
- It allows you to retire mortgage-free so you don’t worry about meeting mortgage payments on a fixed income
- It improves personal net worth by providing you with an asset (your house) without a corresponding liability (a mortgage)
- It provides peace of mind and financial security should your household suffer a reduction in income due to job loss or illness
How Much Money Can You Save?
The interest saved by paying off a mortgage early is significant, even when mortgage rates are low. For example, a couple who makes only the regularly monthly scheduled payments of $954.83 on a $200,000 mortgage at 4% amortized over 30 years pays a total of $343,072.35. $143,072.35 of that is interest.
If they pay the mortgage off in 20 years, the total interest paid drops to $90,203.89, for interest savings of $52,868.46. If they pay it off in 15 years, the interest is only $65,620.89, saving $77,451.56.
How to Pay Off Your Mortgage Faster
Whether or not you have a prepayment penalty mortgage, when you do make an extra payment, confirm that it will be applied directly to the mortgage principal instead of the outstanding interest or escrow account, which won’t save future interest costs. Also, consider several other methods to pay off your mortgage faster:
1. Make Anniversary Date Payment Increases
One way to expedite the completion of your mortgage payments is to increase the payments on the anniversary of your mortgage. However, if your mortgage lender allows it, you can make mortgage payment increases at any time. If you don’t have a prepayment penalty, pick one day a year and increase your mortgage payments. The idea is to commit to increasing your principal payments annually to whittle away at the interest. Some prepayment penalty mortgages allow fixed percentage payment increases of 5% or 10% on the mortgage anniversary date.
2. Make Lump-Sum Prepayments During the Mortgage Term
A lump-sum prepayment refers to an amount of money applied to your mortgage principal during the term of the mortgage. For mortgages with a prepayment penalty, a lump-sum payment uses some or all of your principal pay-off allowance. For some mortgages with prepayment penalties, this can be done on any day during the mortgage term, but the total annual prepayment is limited to a percentage of the original mortgage amount. Others only allow lump-sum prepayments on the mortgage anniversary date. Mortgages without a prepayment penalty don’t limit lump-sum prepayments.
For instance, if a couple makes an annual additional payment to their mortgage of $10,000 each year, they will save 12 years of payments and a total of $90.287.02 in total mortgage interest.
When negotiating the terms of your mortgage, think carefully about your ability to pay off your mortgage early. While mortgages with penalties may be attractive due to their lower interest rates, if your financial situation changes and you want to start making extra payments, you will face stiff penalties and charges.
If you do choose a prepayment penalty mortgage, request a higher prepayment “privilege” than offered. If the mortgage allows a 10% annual prepayment, ask for 15%. This is something that few people ask for and fewer people actually use, so lenders may be flexible to get your business.
If you are really committed to paying off your mortgage early, choose a mortgage without a prepayment penalty. Yes, your interest rate will be higher, but the ability to make extra payments as you choose can significantly shorten the life of the mortgage, making you mortgage-free faster.
3. Increase Your Payment Frequency
A popular and painless way to pay off your mortgage early is to make biweekly payments instead of monthly payments. On a monthly payment schedule, 12 payments are made in a year, but paying every other week (biweekly) means making 26 payments, or the equivalent of 13 monthly payments annually. Apply the extra money directly toward the mortgage principal. This simple process takes years off a mortgage.
By simply switching from 12 monthly payments of $954.84 to 26 biweekly payments of $477.42, a couple shaves 49.4 months off the mortgage and saves $22,522.40 in interest over the life of the mortgage.
Avoid companies that charge enrollment fees to set you up on a biweekly payment plan. Contact your lender directly and ask if it can be arranged for free. If not, simply send one extra regular monthly payment each year and advise the mortgage lender to apply it directly to the principal.
4. Double Up Your Mortgage Payments
Doubling up mortgage payments means paying twice as much for each regularly scheduled payment. This drastically reduces your outstanding mortgage amount when the extra funds go toward principal. Check the fine print of your mortgage carefully to see whether the double-up amount includes the property tax and mortgage insurance amount as well, and if so, confirm that this portion goes towards your mortgage and doesn’t languish in a tax or insurance account to be applied against future payments.
If a couple doubles up their mortgage payment of $954.83 each month from the time they take the mortgage, they will shave a whopping 19 years off their mortgage. They will pay it off in just under 11 years, and reduce total interest paid from $143,735.88 to $46, 413.58, saving $97,322.30 in interest!
5. Make a Lump-Sum Payment at Mortgage Renewal
For borrowers with a prepayment penalty mortgage, renewal time is a great opportunity to make larger penalty-free lump-sum payments on mortgages. Apply inheritances, work bonuses, or the sale of other assets to your mortgage at renewal to reduce your new mortgage amount. If you can, opt for a penalty-free mortgage at renewal to allow you to make extra payments whenever you want, and shave even more off your interest costs.
Be sure to read the fine print of your mortgage. This is crucial, especially if you think your mortgage includes a prepayment penalty. The best time to go through the mortgage documents is before you sign them. It may not seem like exciting stuff, but hidden in that tiny print are the keys to understanding when and how much you can pay down your mortgage. The opportunity to save thousands of dollars in interest should provide you plenty of excitement.
Once you identify any restrictions on your prepayment options, start looking for ways to find extra money to reduce your mortgage balance, mortgage interest owed, and years until you and your family are mortgage-free.
Which methods do you use to pay your mortgage off faster?