Overview: Should You Payoff Your Mortgage Early
The decision of whether you should pay off your mortgage early or not can be perplexing. We hope to assist you in determining the best solution for your circumstances and to provide you with the information you need to make an informed decision.
There are several factors to consider in making this important decision, such as:
- Is there a prepayment penalty clause?
- Are there any benefits to paying the mortgage off early?
- Do you have other debts that should be paid off before the mortgage?
- Are you at retirement age?
- Can you pay off a mortgage early? Is it financially feasible?
Prepayment Penalty Definition
What is a prepayment penalty? According to The Law Dictionary, a prepayment penalty is defined as “a penalty imposed on the borrower for the complete settlement of the loan before the expected payoff date.” The purpose behind the penalty is to compensate the lender in the event you should pay off your mortgage early. The prepayment penalty is typically equal to six months of mortgage payments.
Where can you find the prepayment penalty clause if you have one? The prepayment penalty clause can be found within your mortgage paperwork; it is usually a part of the mortgage note. The exact location will be different for each mortgage. The language of the prepayment penalty clause will also be different for each mortgage. You should refer to your mortgage paperwork to determine the specifics of your particular prepayment penalty clause or to determine if you have a prepayment penalty clause at all.
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Some prepayment penalty clauses require that a borrower pay a prepayment penalty when selling the house, while others do not. Look for the prepayment penalty clause within the mortgage paperwork in order to determine all the specifics related to your circumstances should you decide to pay off your mortgage early. To be clear, some prepayment penalty clauses are referred to as a prepayment penalty rider. Be sure to understand the language in either clause.
Knowing how much the prepayment penalty might be should you decide to pay off your mortgage early is essential when making this decision. The Nest provides a step-by-step calculation for determining the amount you would owe due to a prepayment penalty clause, found below. When making the decision, or preparing a pros and cons list, of whether you should pay off your mortgage early, it is essential that you are armed with all the facts.
The Nest’s Calculation for determining a prepayment penalty:
1. Determine annual principal pay off allowance – the total amount of principal you are allowed to pay off annually without a prepayment penalty. We will use the number $10,000 to represent the pay off allowance in our example.
2. Determine the current unpaid, remaining balance on your mortgage; calling your service provider will provide you with the most accurate balance. In our example, the remaining, unpaid balance is $85,000. Subtract the pay off allowance from this number. $85,000 – $10,000 = $75,000 is your prepayment principal.
3. Multiply the prepayment principal by your interest rate. We will use 7% in our example. $75,000 x .07 = $5,250. Now, divide this total by 12: $5,250 / 12 = $437.50 for your average monthly interest charge.
4. Multiply the average monthly interest charge by the number of months you will be charged as a condition of the prepayment penalty clause found in your mortgage paperwork. Typically, six months. $437.50 x 6 = $2,625, which is your total prepayment penalty.
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Benefits to Paying Off the Mortgage Early
Being armed with the knowledge of any prepayment penalty clause and calculating the amount, if applicable, should have you ready to determine if there are any benefits to paying off the mortgage early. There are different schools of thought on whether paying off the mortgage early is beneficial or detrimental. We will explore both sides.
Renowned author and speaker, Dave Ramsey, suggests that paying off your mortgage early is along the quintessential path to becoming wealthy (after paying off all other debt and saving some money as an emergency fund). His philosophy, which is based upon his own personal experiences, is that paying off your mortgage early will save you tens of thousands of dollars in interest fees.
As Step 6 of Dave Ramsey’s 7 Baby Steps, it might seem unattainable. However, if you do not shy away from discipline and hard work, this route might be the best approach in deciding how to pay off your mortgage early.
One of Ramsey’s critics suggests that paying off your mortgage early can be riskier than investing your money wisely. The author of the White Coat Investor blog, Jim Dahle, wrote that paying off your mortgage early is a great behavioral practice, but not a great mathematical practice. He argues, “Consider a 3% mortgage, 2% after the mortgage interest tax break. If inflation is 3%, the bank is basically paying you to borrow money after inflation. Even if you only expect 5% out of your investment portfolio, you’re still far better off (mathematically) directing new money into the portfolio than toward paying down the mortgage early.”
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If you were to ask Wes Moss, the host of Money Matters, if you should pay off your mortgage early, he would unequivocally answer YES, you should pay off your mortgage early. He says that eliminating your biggest monthly expense lifts a number of psychological and financial burdens off of you. When questioned about why this is a better approach than investing the money, Moss explains that no one knows if the market is always going to go up, but not having the stress of a monthly mortgage payment is priceless.
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Should I pay off my mortgage early if I have accrued other debts?
Our guess is that no one enjoys paying debts and therefore may procrastinate on making payments. There are some debts that should not be put on the back burner, however.
US News Money states there is good debt and bad debt. The good debt, according to the article, is the kind you probably cannot avoid and the bad debt is the kind you should pay off sooner than later.
Under this theory, the debts that should be paid off sooner rather than later include:
- Revolving credit card debt
- Car loans
- Car insurance premiums
The debts that can be paid off later are:
- Student loans
The author says that if you win the lottery or come into an inheritance, then you should probably pay off your mortgage early. This seems like a no-brainer, but is that the only way you could pay off your mortgage early? Perhaps it is, if you have accumulated other debts.
In that regard, it might be better to pay off the other debts with your winnings and then pay off your mortgage early. Then again, how many people do you know who have won the lottery or received a large inheritance? Let’s not hold our breath on this one; it seems little far-fetched.
Another article, also found on US News Money, written a mere three months prior to the above, states that you could save thousands of dollars and pay off your mortgage early simply by paying approximately $100 extra each month. If this is possible, then paying off your mortgage early might be plausible before paying off other debts. However, the article further states that if you have high interest credit card debts or student loans, then you should focus on paying those off first.
Should I pay off my mortgage early if I’m near retirement?
According to a study quoted by Bankrate, 32% of households owned by someone between the ages of 65 to 74 carried home mortgage debt, and nearly 20% of homes owned by those over 75 still had a mortgage. These numbers did not take into account whether these individuals were retired!
Of those who considered themselves to be retired, at any age, approximately 25 percent of them had a mortgage.
US News Money states that approximately 34% of homeowners in the US have no mortgage. Things to consider before plunging into paying off your mortgage early:
- Income tax deduction for homeownership: Bankrate states that the tax deduction is not significant enough to be missed if you pay off your mortgage early.
- Social Security and taxes: Withdrawing money from retirement to make a monthly mortgage payment affects what you will pay in taxes.
- Retirement funding: If your retirement is not fully funded, then you should focus on funding retirement prior to paying off your mortgage early, according to Schwab.
- Moving: if you have plans to move, paying off your mortgage early might not be beneficial.
Schwab provides the following list as reasons you should pay off your mortgage early:
- If you will have limited or reduced income during retirement, you should consider paying off your mortgage early because this will reduce your monthly expenses.
- You can avoid potential interest-rate risks, thus bypassing market fluctuations that could reduce the value of your home.
- Savings on interest, as described earlier, could potentially be tens of thousands of dollars.
- Peace of mind, for those who value being debt-free, is a great motivator.
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Can you pay off a mortgage early?
A contributing writer for Clark Howard, a consumer expert and successful lifelong entrepreneur, shared six steps that made it financially feasible for him to pay off his mortgage ahead of schedule. He suggests that to be able to pay off your mortgage early, you should:
- Buy a home you can afford.
- Get a 15-year mortgage.
- Set a target pay off date.
- Start automatic biweekly payments.
- Reduce expenses and increase income.
- Reward your success.
If you have already bought a home and have a set term on your mortgage, then the first two steps obviously do not apply. However, there is still hope that you can pay off your mortgage early. It may take some hard work, determination, and discipline, but it is possible.
Following Dave Ramsey, in Baby Step 6, you should start throwing any extra money toward the mortgage. His suggestions for becoming debt-free begin with collecting $1,000 for an emergency fund, then working a lot of extra hours to earn extra income, selling as much stuff as you can, and using a “debt snowball” approach to pay off everything except the house. Once that is accomplished, you should save up an emergency fund of 3 to 6 months of living expenses. Then you can tackle paying off your mortgage early while simultaneously investing 15% of your income and saving for your children’s college.
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The decision to payoff your mortgage early is a hard one to make. Take your time in thinking through the whole process, maybe even making a pros and cons list of paying off a mortgage. Speak with a financial advisor and people who have paid off their mortgage. Read everything you can about the positive and negative implications that might apply in your situation.
Then, whatever your decision, go forward confidently, knowing that you have armed yourself with the knowledge you need to reach your goals.
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