How to pay off a mortgage early

It’s a common enough practice: paying extra on a mortgage to retire the debt early and save a bundle in interest costs. But with interest rates rising, is it still a smart strategy?

Some experts think prepayments are never a good option, as stocks and other investments have paid off better. Others swear by it.

“Paying down your mortgage can fast-track your path to true homeownership and save you from making interest payments over time,” says John Pataky, executive vice president at EverBank in Jacksonville, Florida.

He likes the biweekly strategy of making half the monthly payment every two weeks, or 26 half-payments a year instead of 12 regular ones.

[See: The 25 Best Blue-Chip Stocks to Buy for 2017.]

“This extra monthly payment on an annual basis can take months, or even years, off the overall term of the loan, depending on your remaining balance and payment amount,” says Pataky. “Some banks can set up a biweekly plan and some will accept this plan from a third-party payment service.”

A lump-sum prepayment can work, too, he says. He advises checking with the lender to make sure your account will be properly credited.

“I think the decision to pay off a mortgage depends on a variety of factors,” says Marguerita Cheng, CEO of Blue Ocean Global Wealth in Rockville, Maryland. “I have several clients who will pay off their home in their 60s, the year they retire or within one to five years of retirement, depending on their cash flow, tax status of their investments and tax bracket.”

Paying extra in mortgage principal has a snowballing effect. By reducing the debt, it allows more of every future payment to go to principal and less to interest. And after each future payment, even more will go to principal in the payments that follow.

Imagine a homeowner with a new $300,000 loan at 4 percent and a monthly payment of $1,432.25. In the first month, $1,000 would go to interest and $432.25 to principal. After 10 years, the debt would be down to about $236,000 — $788 would go to interest and $644 to principal. After 20 years, the debt would be down to about $141,000, so the principal would be $960 and the interest $472. The final payment would be $4.75 in interest and $1,425 in principal.

Over the life of the loan, the borrower would pay back the $300,000 borrowed and hand over $216,000 in interest.

Putting $100 extra per month into the loan would allow the borrower to pay off the $300,000 3.5 years early, reducing total interest paid by nearly $29,000.

With an adjustable-rate mortgage it’s a little different. After the initial teaser period ends, the loan is recalculated every 12 months to apply the new interest rate to the remaining debt for the number of years left on the loan. Paying extra reduces the payment required after the next annual reset, but does not reduce the years the loan will last. To retire the loan early, the borrower can continue making larger-than-required payments.

[See: 13 Tips for Singles Nearing Retirement.]

Extra principal payments have no effect on the home’s appreciation, or rising value in the marketplace, but do increase the homeowner’s equity, the difference between current market value and remaining debt. Many people try to pay off their loans before retiring to reduce monthly expenses and have more equity that can be tapped for living expenses through a downsizing or reverse mortgage.

With either type of loan, the borrower must make a choice about the best way to spend extra cash. Extra principal payments have an investment return equal to the loan rate. On the fixed-rate loan above, paying extra earns 4 percent because every $100 in principal reduction saves the borrower $4 a year in interest charges. With an ARM, the return is harder to predict, since the savings involves the various interest rates the borrower will be charged in the future.

The borrower with the fixed loan can weigh the 4 percent return on the mortgage prepayment against what could be earned in another investment. Over long periods, she might earn more in the stock market if she’s willing to take on more risk. But because the prepayment has a guaranteed return, it makes sense to look at low-risk alternatives with comparable guarantees, like bank savings or top-quality bonds.

Currently, a five-year CD pays only about 1.2 percent, and the 10-year U.S. Treasury just 2.5 percent, so a mortgage prepayment earning 4 percent looks like a better choice. Of course, the prepayment is an illiquid investment, since the only way to get that cash back would be to sell the home or take out a new loan. A stock or bond investment could be converted to cash in a day or two.

With interest rates rising, the homeowner considering prepayments must think about what that cash could earn in the future, not just today. If Treasury bonds started paying 5 or 6 percent, the homeowner might kick herself someday for tying money up in the home at only 4 percent, but not may forecasters think Treasuries will pay that much any time soon.

Cheng says that it generally pays to reduce debts with higher rates before tackling the mortgage.

Of course, you do more than one thing at once, dividing new cash between mortgage prepayments and other investments, just as you’d diversify among stocks and bonds.

But be sure extra principal payments don’t come at the expense of building a proper rainy day fund or being able to comfortably pay ordinary expenses, Cheng says.

[See: 6 Strategies To Avoid Working in Retirement.]

“While I don’t want clients starting retirement with a large mortgage balance, the flip side is that clients need cash flow,” she says. “It’s nice having a home that you own free and clear, but you still need to buy food, put gas in your car and live life.”

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