You can pay off your mortgage early by refinancing into a shorter-term mortgage, paying a little more each month, making an extra mortgage payment every year, or throwing “found” money at the mortgage.
If you can afford it, it might be simple to pay off your mortgage earlier. But should you? That’s a complicated question.
Homeowners with low mortgage rates may be better off putting extra money in a Roth IRA or 401(k), both of which might offer a higher return than paying off the mortgage.
Then there’s the college aid factor. If you’re applying for need-based aid for your kids, that home equity could count against you with some colleges because some institutions view equity as money in the bank.
If, after those caveats, you want to pay off your mortgage early, here are four ways to make it happen.
1. Refinance with a shorter-term mortgage
You can pay off the mortgage in another 15 years by refinancing into a 15-year mortgage.
Let’s say you got a 30-year fixed-rate mortgage for $200,000 at 4.5 percent. Then, five years later, you can refinance into a 15-year loan at 4 percent. Doing so pays off the mortgage 10 years earlier and saves more than $60,000 (if you exclude closing costs on the refi).
Those shorter-term mortgages often carry interest rates a quarter of a percentage point to three-quarters of a percentage point lower than their 30-year counterparts.
Refinancing isn’t quick or free. It requires filling out the application, providing documentation and having an appraiser visit. There are closing costs.
And even with a lower interest rate, that quicker payoff means higher monthly payments. And this method is a lot less flexible. If you decide that you don’t have the extra money one month to put toward the mortgage, you’re locked in anyway.
Unless the new interest rate is lower than the old rate, there’s no point in refinancing. Without a lower rate, you’ll get all the same benefits (and none of the extra costs) by just increasing your payment a sufficient amount.
2. Pay a little more each month
Divide your monthly principal and interest by 12 and add that amount to your monthly payment for a year. Result: You make the equivalent of 13 payments in 12 months.
Let’s say you got a $200,000 mortgage at 4.5 percent. After five years of making the minimum payments, you add an extra 1/12 of a month’s principal and interest to each monthly payment. Doing so pays off the mortgage three years and three months earlier and saves more than $18,000 interest.
Before you make anything beyond the regular payment, call your mortgage servicer and find out exactly what you need to do so that your extra payments will be correctly applied to your loan.
Let them know you want to pay “more aggressively” and ask the best ways to do that.
Some servicers may require a note with the extra money or directions on the notation line of the check.
In any event, if you’re putting extra money toward your loan, always check the next statement to make sure it’s been properly applied.
3. Make an extra payment every year
Instead of paying a little more each month, make one extra monthly payment each year. One way to do this is to save 1/12 of a payment every month, and then make an extra payment after every 12 months. This gives you the flexibility to use the extra savings for something else if a more pressing expense arises.
Let’s say you do this starting the first month after getting a 30-year mortgage for $200,000 at 4.5 percent. That would save more than $27,000 interest, and you would pay off the mortgage four years and three months earlier.
4. Throw ‘found’ money at mortgage
Get a bonus? A tax refund? An unexpected windfall? However it ends up in your hands, you can funnel some or all of your newfound money toward your mortgage.
Let’s say you got a 30-year, fixed-rate mortgage for $200,000 at 4.5 percent. Then, five years later, you can make an extra $10,000 lump-sum payment. Doing so pays off the mortgage two years and four months earlier, and saves more than $19,000 in interest.
The upside: You’re paying extra only when you’re flush. And those additional payments toward the principal will cut the total interest on your loan.
The downside: It’s irregular, so it’s hard to predict the mortgage payoff date. If you throw too much at the mortgage, you won’t have money for other needs.
Mortgages 101: What is a ‘point’?
When people want to find out how much their mortgages cost, lenders often give them quotes that include loan rates and points.
What exactly is a point?
A point is a fee equal to 1 percent of the loan amount. A 30-year, $150,000 mortgage might have a rate of 7 percent but come with a charge of one point, or $1,500.
A lender can charge one, two or more points. There are two kinds of points:
• Discount points
• Origination points
Discount points are actually prepaid interest on the mortgage loan. The more points you pay, the lower the interest rate on the loan, and vice versa. Borrowers typically can pay anywhere from zero to three or four points, depending on how much they want to lower their rates. This kind of point is tax-deductible.
Origination points are charged by the lender to cover the costs of making the loan. The origination fee is tax-deductible if it was used to obtain the mortgage and not to pay other closing costs. The IRS specifically states that if the fee is for items that would normally be itemized on a settlement statement, such as notary fees, preparation costs and inspection fees, it is not deductible.
How do you decide whether to pay points, and how many? That depends on a number of factors, such as:
• How much money you have available to put down at closing.
• How long you plan on staying in your house.
Points as prepaid interest reduce the interest rate, an advantage if you plan to stay in your home for a while.
But if you need the lowest possible closing costs, choose the zero-point option on your loan program.
As an example, a lender might offer you a 30-year fixed mortgage of $165,000 at 6 percent interest with no points. The monthly mortgage principal and interest payment would be $989.
If you pay two points at closing (that’s $3,300) you might be able to drop the interest rate down to 5.5 percent, with a monthly payment of $937. The savings difference would be $52 per month. But it would take 64 months to earn back the $3,300 spent upfront via lower payments.
If you’re sure you will own the house for more than 5½years, you save money by paying the points.