For most of us, there's an implicit understanding that buying a home will nearly drain your bank accounts. You'll shell out for the down payment, the home inspection, and—just when you think you're done—the closing costs.
OK, you're forking over a ton of cash upfront, but once you're past that, you're golden, right? You are—until you remember that you have to actually make payments on that mortgage you got. And the interest. For the next 30 years. And 30 years of paying 4% interest on your $200,000 mortgage can seem like indentured servitude—especially when you consider that those interest payments add up to tens of thousands of dollars over the life of your loan.
But what if you could pay off your mortgage in less time—and whittle down that crazy interest you’re forking over each month? Apparently, it can be done—and you don't have to go broke in the process. Here are four expert-approved tips to get you started and on your way to putting money back in your wallet.
1. Make one extra payment each year
Have a bonus coming up? Did you get a windfall from a beloved grandparent? If you make one full payment at the end of the year and apply it to your mortgage principal, you could knock off a few years from your loan, says Elise Leve, senior loan officer with Citizens Bank in New York City.
“It’s easy to pay off a mortgage earlier now because most lenders don’t have prepayment penalties,” Leve says. “Making just one extra payment a year on a 30-year loan shaves about four years off your loan.”
You can opt to make the extra payment at the end of the year, or any time you get a lump sum of money, Leve says. Just make sure to indicate it should be applied to your principal.
2. Add a little extra to each monthly payment
If making smaller, more manageable payments is more in line with your comfort level and budget, you can do that, too. For example, let’s say you have a $200,000 mortgage with a fixed interest rate of 4% for a 30-year term. The total amount you’d pay for that 30-year loan in interest alone is $143,739. Ouch.
But say you made an extra $100 payment toward your principal each month over the lifetime of your mortgage. You’d shave five years off your loan and pay nearly $27,000 less in interest. That’s huge!
As with extra annual payments, make sure you earmark these additional monthly payments specifically for your principal. Otherwise, the extra money will get absorbed into the following month’s mortgage payment, says Ethan Vickery, a real estate agent with TripleMint in New York City.
“Call to make sure your lender applies those extra principal payments correctly; otherwise, you won’t get the benefit you’re looking for,” Vickery says.
Keep in mind this strategy is not the same as setting up biweekly payments, splitting up your monthly payment into two smaller ones. While biweekly payments will help you reach your goal faster, you're locked in—miss a payment, and you'll be hit with fees and/or hefty penalties.
In most cases, experts suggest simply making an extra payment when you can—whether that's once a year or every other month—instead of committing to a biweekly schedule.
3. Refinance to a shorter-term loan
If you bought your house when interest rates were higher, refinancing from a 30-year mortgage to, say, a 15- or 10-year loan will save you a huge chunk of change on interest, says Tim Beyers, a mortgage analyst with American Financing in Aurora, CO.
But be forewarned: Although shorter-term loans tend to have much lower interest rates, you generally need to have at least 20% equity, based on your home’s current market value. Otherwise, you’ll be stuck with private mortgage insurance, Beyers says.
Another thing to keep in mind: With a shorter-term loan, monthly mortgage payments will go up considerably, and you’ll have to pay closing costs to refinance your loan, too. Ask your lender to crunch the numbers to determine when you’ll break even on those costs, especially if you don’t plan to stay in your home for the long term, Beyers says. In that case, refinancing is probably not the best move.
A note about FHA loans: Refinancing a loan backed by the Federal Housing Administration, or FHA, has the added perk of eliminating mortgage insurance premiums. The annual premium can range from 0.45% to 1.05% of the original loan amount (depending on the length and size of the loan). And, generally, FHA borrowers are stuck with those premiums for the life of the loan, Leve says.
“Refinancing from an FHA to a conventional loan as soon as you possibly can once you meet loan-to-value requirements [for refinancing] will save you a significant amount of money,” Leve says.
4. Create your own amortization schedule
You don’t have to refinance in order to pay off your loan early at the same rate. With an amortization schedule, you can skip the fees and closing costs of a refinance and figure out the monthly payment you’d need to pay off your loan within your desired time frame.
An amortization schedule is a more aggressive (and structured) tactic than simply tossing a little extra cash at your mortgage principal each month. If done right (with your mortgage lender's help), an amortization schedule will mimic the effect of refinancing from a longer-term loan to a shorter-term period, minus the fees and paperwork. Keep in mind that it won’t change your regular monthly payments or cut down your interest right away, but it will lessen your repayment time (perhaps by as much as 10 or 15 years!) which, in turn, saves you heaps on interest.
This method will take a lot of discipline and consistency on your part in order to work. Ask your lender to help you crunch numbers and figure out a precise target payment amount.
Can I really afford to pay off my mortgage early?
Being debt-free is undoubtedly appealing. Being able to achieve it largely depends on your financial goals and income. Here are some questions to ask yourself:
- Is my income stable enough to make higher monthly payments if I refinance to a shorter-term loan?
- Am I meeting other financial goals (e.g., saving for retirement and my kids’ college fund)?
- Have I paid down high-interest credit cards?
- Do I have an emergency fund if times get tough?
- Is my credit score solid?
- Do I plan to stay in my home for at least 20 or 30 years?
If you answered yes to all of these questions, you’re in a great position to focus on knocking down mortgage debt. If not, talk to a financial adviser for some direction, Beyers says.
“Really examine what you’re trying to achieve,” Beyers says. “Sure, you’ll take 10 or 15 years off your loan by refinancing. But if you’re diverting that money away on a monthly basis from your child’s education or other financial obligations, is that what you want?”