Money Girl answers a listener question about paying off a mortgage early and explains when to do it--and 3 situations when it’s a bad idea.
A Money Girl podcast listener named Julie asks:
I have $20,000 that I’d like to use to pay down my mortgage balance, which is about $100,000, and has no prepayment penalty. What’s better--sending the full amount at once, or simply increasing my monthly payment over a period of time?
In this episode, I’ll answer Julie’s question, and discuss the pros and cons of paying off a home loan ahead of schedule. You’ll also learn about 3 particular situations when it’s a bad idea to pay down your mortgage early.
Advantages of Paying Off a Mortgage Early
Let’s start by reviewing the main advantages of paying off a mortgage early. The most obvious benefit is that reducing the balance of a mortgage allows you to pay it off in less time, and to pay less interest over the life of the loan.
For example, if you owe $150,000 on a 30-year, fixed-rate mortgage at 5%, your monthly payment for principal and interest will be about $800. If you have the mortgage for 30 years, you’ll end up paying a total of $140,000 in interest.
But let’s say that after making payments for 4 years, you get a $20,000 windfall and decide to use it to pay down your mortgage. If you keep making the $800 monthly payment, you’ll pay off the loan in a total of 23 years instead of 30. Plus, you’ll cut the total interest that you have to pay from $140,000 to $98,000—saving about $42,000 in interest over the life of the mortgage.
Additionally, paying down a mortgage ahead of schedule means you have more equity in the home. Equity is the difference between a home’s value and what you owe. For instance, if your home is worth $200,000 and you owe $150,000, you have $50,000 in equity.
Having more home equity can help you qualify to refinance your mortgage for a lower interest rate, or to eliminate paying private mortgage insurance to your lender.
The main con to paying down a home loan early is that once you send the money, it’s tied up in your property.
Disadvantages of Paying Off a Mortgage Early
While getting out of debt sooner rather than later is generally a good idea, there are disadvantages to prepaying a mortgage that you should weigh carefully. Always consider your mortgage in the context of your entire financial situation.
The main con to paying down a home loan early is that once you send in the money, it’s tied up in your property. If you unexpectedly lose your job or suddenly have a large expense, you won’t be able to get that money back easily--if at all.
Money you send to a mortgage, either as a lump sum or by increasing your monthly payment, may be better spent on chipping away at more expensive, higher-rate debt, such as credit cards, payday loans, or student loans.
Additionally, you may be losing out on the opportunity to invest your extra money for returns that are higher than the rate you’re paying on your mortgage. For instance, investing in a mutual fund that pays you an average annual return of 8% is better than paying down a mortgage that costs you 5%.
See also: Should I Pay Off My Mortgage or Invest?
3 Situations When You Should Never Pay Down Your Mortgage Early
Having a paid-off mortgage is terrific—but not if it would leave you without enough available cash or a retirement nest egg.
Here are 3 situations when you should never pay down your mortgage ahead of schedule: