Should you pay off your mortgage early?

Debt is a growing concern for many Americans today. When you have credit cards, student loans and a mortgage, it’s difficult to decide which debts to tackle first. For some, it might make sense to pay down your mortgage as quickly as possible — but this isn't always the case.

Can you pay off a mortgage early?

It’s possible to pay off your mortgage early if you have the financial means to do so. Most conventional loans today have no prepayment penalties (fees imposed by the lender for paying off your mortgage earlier than scheduled). Any fees or penalties associated with the loan will be mentioned in the disclosure documents you sign and receive at closing, so make sure you’re familiar with the mortgage lender’s terms.

Prepayment penalties are illegal under federal law for some types of mortgages, including FHA loans, USDA loans and VA loans. You may have to follow other lender guidelines for prepayment, which could include providing written notice in advance of the prepayment.

How to pay off a mortgage early

There are a few ways to pay off your mortgage early. For one, you can add additional funds  — say an extra $50 — to your monthly mortgage payment. You’ll need to clarify that these funds should go toward the principal; otherwise, the lender might apply it toward the following month’s payment. Most lenders let you assign the extra payments to the principal online.

Adding just $50 to each monthly payment could save you thousands of dollars in interest.

Even a small amount tacked on to your required payment can save you thousands of dollars in interest over the life of the loan. On a $250,000 mortgage at 3.25% for 30 years, an extra monthly payment of $50 can cut at least two years off the mortgage and save you $11,405.09 in interest.

You can also make additional one-time or irregular payments during the year. For instance, you may want to apply some of your tax refund toward your loan principal. Even if these extra payments are inconsistent, they can help you shorten the loan and save money in interest.

Refinancing is a common early repayment tactic. This essentially means you take out a new loan to pay off the current loan, then start your mortgage over based on the remaining loan balance and the equity you’ve established.

For example, if you currently have a 30-year mortgage you’ve been paying off for four years now, you may decide to refinance to a 15-year mortgage. Refinancing to a shorter term is likely to increase your monthly payment, but it will also cut the amount of time you pay interest.

You may also choose to refinance to another 30-year term when interest rates are lower so you can get a reduced monthly payment. This offers more flexibility in your budget to pay off the loan early. Keep in mind that refinancing, just like any other loan type, still has associated fees.

Pros and cons

There's no simple answer as to whether you should pay off your mortgage early. Every person's situation is different, and it's important to consider the advantages and disadvantages.

Pros

• Eliminate a monthly payment: Paying off your mortgage sooner will help you eliminate a monthly payment obligation. You can use those extra funds for things like investing more into your retirement account.
• Save money in interest: You’ll save money in interest over the life of the loan, even if you only pay off the mortgage a few years early. Interest is calculated on the remaining principal, so reducing principal quickly will result in less interest paid.
• Increase equity: Paying off principal also increases your equity in the home, which can help when you decide to sell. If you need cash but aren’t planning to sell, you could do a cash-out refinance that lets you withdraw some of the equity you’ve built up as part of a new loan. And, of course, if you pay off your entire home loan early, you own your home outright sooner.
• Reduce PMI payments: Private mortgage insurance (PMI) is required on a conventional mortgage when you put less than 20% down. You’ll pay it until you’ve built 20% equity in the home. The sooner you can pay down the loan balance, the sooner the PMI will drop off your monthly payments. PMI costs about 0.5% to 1% of the loan amount annually.

Cons

• Lose the opportunity to invest in other ways: The money you use to pay off the mortgage early could be invested in stocks, bonds, mutual funds or other investments instead. Many of these earn higher average returns than the “return” you get by paying off your mortgage. For example, the stock market has an average return of 10% annually, according to the Securities and Exchange Commission, so you're losing out on potential profit if you’re paying off a loan with 3.5% interest with funds you could have made 10% on.
• Cash tied up in illiquid investment: If your home is one of the few investments you own, you could be in a predicament if you suddenly need access to cash. Houses are considered illiquid investments, which means they can’t be converted to cash easily. You have to first find a buyer, negotiate the price and then complete the closing process. Even in the best housing markets, the closing process and the ultimate transfer of funds could take a few weeks to settle.
• Lose the mortgage interest deduction: The interest you pay on your mortgage is tax deductible, which means it helps reduce the amount of income taxes you pay each year. Paying off the loan means you’ll no longer have this tax deduction. However, most individuals choose to take the standard deduction, which means they don’t use the mortgage interest deduction.
• Prepayment penalty (if applicable): Some mortgages have a prepayment penalty, charging a percentage of the balance if you pay off the loan in full early. This charge puts a dent in the amount of money you save in interest charges.

When it makes sense

It may make sense to pay off your mortgage early if you’re near retirement. You may choose to pay off all debt, including your mortgage, before you retire and are on a fixed income. Many individuals make less money in retirement than in their working years, so you may need the additional funds to cover your regular living expenses.

It may also make sense if you have a great deal of extra income each month, even after funding savings and retirement accounts. Also, if all your other debt has been paid off, like credit card debt and student loans, you may want to explore early mortgage repayment. It’s a good idea to calculate the interest savings compared with potential returns on your investments, though.

When it doesn’t make sense

It doesn’t make sense to allocate additional funds to your mortgage if you have other debt with a higher interest rate. In most cases, mortgages have some of the lowest interest rates available (credit cards have some of the highest).

For comparison, the average mortgage rate on a 30-year fixed conventional loan is 4.173%, and the average rate for credit cards is around 16% at the time of publishing. If you have lots of credit card debt, it makes more sense to pay that off and build an emergency fund (three to six months of living expenses) before paying off your mortgage early.

Early mortgage repayment also doesn’t make sense if you can invest the funds to make a higher profit than the interest you’re being charged on the loan. By paying $50 more a month for just under 30 years, you could save a little over $11,000 in interest. However, if you invested that same $50 a month and earned 6% on average annually, your investment would be worth $50,778.01 after 30 years. That’s a profit of $32,778.01 on your $18,000 total investment.

Finally, it doesn’t always make sense to pay off your mortgage early if you have an expensive prepayment penalty that costs more than what you’d save in interest.

Bottom line

Before choosing to pay off your mortgage early, you’ll want to consider your financial situation. Think about your short- and long-term goals and the overall liquidity of your investments — how much cash could you get access to if you need it in a pinch?

In most cases, you may be better off putting extra funds into investment or retirement accounts that can earn a higher return over the long term. On the other hand, maybe you are the type of person whose top priority is owning your home free and clear. If you’re having difficulty deciding what to do, it may make sense to speak with a financial advisor about your options.