For many, owning a home is a big part of the American Dream. And it’s easy to see why: In addition to being one of the single largest investments the average American makes during his or her lifetime, a home is where you’ll make memories as you raise your family.
Most Americans rely on a mortgage to finance and purchase a home, and the average amount owed on a mortgage in the United States is around $157,000 (though this amount varies substantially depending on what state the home is in).
It may feel like you’re going to be paying forever (especially if you have a 30-year mortgage). But with the right information and strategy, you can pay down your mortgage faster — and save a lot of money along the way.
ANATOMY OF A MORTGAGE
Mortgages, like all other loans, consist of principal and interest. The principal is the amount that you borrowed that must be repaid; the interest is what you must pay on top of the principal. The interest is how a bank or loan servicer makes money from lending to you.
Interest rates on mortgages are determined by a number of factors. Some of those are in your control — like your credit score — and some are not.
Interest rates can be either fixed or adjustable. Fixed rates do not change over time unless you refinance your loan; adjustable rates are typically fixed for a certain amount of time, after which the rate may go up or down based on the market.
The most common term — how long it will take to pay off the loan — for a mortgage is 30 years, though 15-year mortgages are increasingly popular. Though a longer-term loan usually means lower monthly payments, they also tend to come with higher interest rates. In most cases, opting for a 15-year mortgage over a 30-year mortgage can lead to substantial savings on interest.
STRATEGIES FOR PAYING DOWN YOUR MORTGAGE
When it comes to paying down your mortgage ahead of schedule, a lot of options are available.
PAY MORE THAN THE MINIMUM
The easiest way is to simply make an additional payment each month; every extra dollar you pay toward the principal is one more dollar you are no longer paying interest on. An easy way to do this is to simply round up your payment each month. If you do this, make sure your lender knows you want the extra payments applied to the principal of your loan.
For example, if your monthly mortgage payment is $1,023, rounding your payment to $1,100 will help you pay off an additional $77 of loan principal each month. That’s $924 over the course of a year, and $27,720 over the life of a typical 30-year mortgage. Not too shabby for $77 extra each month!
Those extra payments mean you will pay off your loan more quickly.
MAKE BIWEEKLY PAYMENTS
You could also follow a biweekly payment schedule to pay down your mortgage more quickly. Doing this means that you’ll make a half payment every two weeks instead of a full payment each month. Again, make sure your lender knows you want the extra payments to cover the principal.
Because there are 52 weeks in a year, you’ll be making 26 half-payments each year, which equals 13 full payments. Voila! Without even thinking about it, you’ve made a whole extra payment on your mortgage.
In essence, refinancing entails taking out a new loan so that it can be used to pay off an existing loan.
There are several ways refinancing a mortgage can help you save money. It can help you get a lower interest rate (and, therefore, a lower monthly payment). You might be able to switch to a shorter loan term which will likely result in higher monthly payments but will save you money in interest over the life of your loan. You could also switch to a fixed-rate loan from an adjustable-rate loan (or vice versa). Typically an adjustable rate mortgage will offer a lower interest rate up front (meaning you could save money in the short term, however the payments could increase over time). On the other hand, if you have an adjustable rate mortgage that is about to adjust up, switching to a fixed rate loan could save you money over time.
Typically, it also makes sense to look into refinancing if your credit score has improved since you first took out your mortgage or if market rates have fallen. If you’re able to lower your interest rate and monthly payment but pay the same amount as you were before, you’ll pay off the mortgage faster.
When refinancing, it’s important to make sure whether you’re paying closing costs or not as the extra costs may offset any savings you’ll get.
You could follow a biweekly payment schedule to pay down your mortgage more quickly.
KNOW THE CONSEQUENCES OF PAYING OFF YOUR MORTGAGE EARLY
Paying off a mortgage early can have a lot of positive outcomes: Money saved in the form of interest; more room in your budget; peace of mind in case of financial trouble. But it can also have some negative consequences that you need to keep in mind.
The first is that, like some car loans, paying off your mortgage early sometimes results in a prepayment penalty or fee. Whether or not you can expect a prepayment penalty, and details about what this penalty might be, are laid out in your mortgage agreement — so be sure to read the fine print.
The other thing to keep in mind is how paying off your mortgage will impact your taxes. If you are paying interest on a mortgage, you are typically allowed to write off at least a portion of this interest when you file your federal income taxes each year. Though paying off your mortgage will result in interest savings, you will lose this tax benefit, which will impact your tax bill.
Finally, if you have a low mortgage rate, let’s say 3.5 percent, you may actually be able to make more money by investing the cash you would use to make extra payments on your mortgage. You should consider all your debts and options to save for the future before deciding whether to make extra payments.
All investing carries some risk, including loss of principal invested.