Should You Repay Your Mortgage Early?

How can you repay your mortgage early?


There are two ways mortgages can be paid off early. The first way is to pay an extra amount in addition to your normal monthly payment. This amount pays off a part of the debt. Overtime, these extra mortgage payments can result in earlier payoff of the loan. They also let you save on interest cost, because you will be charged interest for a reduced outstanding balance, following in extra payment. The second way a mortgage can be repaid early is by simply paying off the outstanding amount and any penalty imposed by the bank. Check with your bank on the conditions and restrictions for paying off the mortgage early and making extra payments.


How do extra mortgage payments reduce your interest cost?


When you make an extra payment, you avoid the interest cost of the extra payment amount for the remaining term of your mortgage. In addition, more of the monthly payment in subsequent months gets allocated to the repaying the loan, which can cause an earlier payoff.


Suppose you have a mortgage with 3% interest and 10 years left in the term, and your outstanding balance is $100,000. Let's compare paying off $1,000 now, with sticking to the normal payments plan. Our extra payments savings calculator, makes this comparison easy by showing you the differences in payments each month, along with the resulting savings and new payoff date.


Scenario:

  • $100,000 outstanding balance
  • 3% interest
  • 10 years to go

Without extra payments:

  • Loan paid off after 120 months
  • $15,872.91 in interest payments

With $1,000 extra payment now:

  • Loan paid off on 119 months

  • $15,527.81 in interest payments

  • Savings of $345.05


Paying $1000 to save $345.05. Isn't this interesting?


How will you see this saving? The last payment you make, on month 119, would be $585.00 which pays the interest and the remaining balance. If you had not made the $1000 extra mortgage payment, you would instead pay $965.61 on month 119, and still owe $961.92 to be settled on month 120 along with $2.40 interest. Here are the differences:

WithWithout
Month 1-$1000$0
Month 119-$586.17-$965.61
Month 120$0-$965.61

When you add up the columns, you see the difference is $345.05, and $345.05 is 34.51% of your $1000 payment.


"A penny saved is a penny earned."

Benjamin Franklin

Your $1000 payment acts like like an investment that pays 34.51% in 10 years. It is the same as investing the $1000 and getting back $1345.05 in 10 years. After using this $1345.05 to cover the last two months, you are in the same state as if you had made the extra payment instead.


Are there other options where you are better off not making the extra payment to your mortgage?


What other things can you do with a $1000 instead of using it for an extra mortgage payment? You've guessed it! One option is to spend the $1000. You could also let the $1000 sit in your bank account for 10 years. Only you can decide on the benefits of the former in your situation, and whether it is better than saving $345.05. As for keeping the money in the bank for 10 years, your $1000 would get eroded by inflation unless you earn sufficient interest.


Another option would be to invest the $1000. Is it possible to get a return better than 34.51% in 10 years, after tax? Yes, of course. Is it possible to achieve this return with zero risk?


U.S. Treasuries are backed by "the full faith and credit" of the US government, and are considered the safest investments available. Suppose that you can get an annual return of 2% from U.S. 10 Year Treasury notes, after taxes, and you reinvest the interest earnings every year. This would give you a return of 21.90% after 10 years, which doesn't beat the 34.51% saving you get from a $1000 extra mortgage payment. For zero risk, the extra payment is the better choice.


How much would the yield need to be, after tax, to match the the 34.51% savings from an extra mortgage payment? That is easy to find out:

(1+yield)10=1.34511+yield=1.34511/10yield=0.030091=3.0091%\begin{alignedat}{3} (&1 + &\text{yield}&)^{10} \quad &=& \quad 1.3451 \\ &1 + &\text{yield}& \quad &=& \quad 1.3451^{1/10} \\ & &\text{yield}& &=& \quad 0.030091 \\ & && &=& \quad 3.0091\% \\ \end{alignedat}

If your after-tax yield from Treasures exceeds 3.0091%, then making the $1000 extra payment to your mortgage isn't the best option. You would get a better result, for the same risk, investing in Treasury notes. If your risk appetite allows, you could instead take on riskier investments that have a better yield.


Extra mortgage payment decision guide


Assuming you have some spare money that you don't need for the remaining term on your mortgage, paying off the mortgage quicker with extra payments can be an attractive choice. Here is how you can decide on whether making extra payments is the best option for you:


  • Using our extra payments savings calculator find out the savings you would get from extra payments.
  • Find out the yield on risk free investments such as U.S. 10 Year Treasury notes, and how much tax you would need to pay. Taxation depends on factors such as your residency and income level. Calculate the resulting after-tax yield, over the remaining term of your mortgage.
  • If the after-tax yield from risk free investments exceeds the savings you get from the extra payments, then you are better off pursuing the other options instead of extra mortgage payment.
  • Consider also your risk appetit and whether you prefer risker, higher gain investments.

The take-away from this post is that there is no "one size fits all" best approach when it comes to extra mortgage payments. You need to evaluate all your options so that you can find the solution that works best for you and take a decision with confidence. You are now better armed with a process and tooling to help you.

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