If you are interested in getting completely out of debt, paying off your mortgage may be the largest hurdle. Here is a list of strategies for paying off your mortgage early. Most of these strategies can be evaluated using the free Home Mortgage Calculator spreadsheet. With that spreadsheet you can estimate how much overall interest you can save as well as see how many years you can knock off the mortgage.
Extra Payments, Extra Payments, Extra Payments
Before I start talking about the strategies, you should know that paying off a loan early means that you have to make extra payments on the principal. Assuming that foreclosure and bankruptcy are not options you want to consider, you eventually have to pay back what you borrowed, plus some interest. Most accelerated mortgage strategies involve either a method for making extra principal payments, or a method for reducing the interest portion of the payment so that more can be applied to the principal, or a combination of both of these methods.
IMPORTANT: When making an extra payment on the principal of a loan, make sure to find out what the lender requires from you to indicate that the payment is principal-only. It might involve writing "principal-only" on the check, or selecting a "principal-only" option when paying online. You don't want your extra payment treated as just a prepayment or early payment of the next bill.
The following strategies are not necessarily exclusive. You may be able to mix and match some of them.
Selling your home to either rent or purchase a smaller home with the equity that you've built up is the fastest way that I know of to get out from under a heavy mortgage. Unfortunately, if you currently owe more than your home is worth, this might not be an option (or at least not as simple or pleasant).
2. Accelerated Bi-Weekly Payments
I've had more questions about this over the years than any other option. This is a common term used for Canadian mortgages, but people often confuse "accelerated" plans with normal bi-weekly payment plans. Paying bi-weekly (every two weeks) vs. monthly does almost nothing to help you. It is the "accelerated" part (the extra payment) that does the trick.
In short, the "Accelerated Bi-Weekly" payment is 1/2 of a normal Monthly payment, but you end up making 26 payments per year (instead of 24 if you were paying a true semi-monthly payment). This is a convenient way to make extra payments on the principal automatically every time you get your bi-weekly paycheck. The effect is that by the end of a year, you will have made roughly the equivalent of 1 extra monthly payment towards the principal.
The amount of time you can shave off your mortgage using the accelerated bi-weekly approach does not depend on the size of the loan, but it does depend on the interest rate. Here is a table that shows how many years you can shave off a 30-year mortgage based on the interest rate.
|Interest Rate||Years Shaved Off|
BEWARE: Be careful when considering using third party equity accelerator plans that charge fees for managing your bi-weekly payments. If the lender itself doesn't offer a true accelerated bi-weekly option, then the third party might just be keeping your bi-weekly payments on hold, paying the normal monthly payment, and then making an extra principal payment a couple of times per year ... something that you can do yourself without any fees.
3. Treat a 30 like a 15
A smart home buyer will purchase a home only if they can afford the 15-year mortgage payment. Contrary to popular belief, getting a 30-year mortgage and paying as if it is a 15-year mortgage is NOT the same as getting a 15-year mortgage from the get-go. Why? Because a 15-year mortgage will almost always have a lower interest rate!
With that said, let's assume now that you don't have the option of going back in time and getting the 15-year mortgage ...
You can still make the effort to schedule your extra payments based on whatever end-goal you want to achieve. Perhaps you can't afford to pay off your home in 15 years, but maybe you could try for 20 years.
The limit to how fast you can pay off your mortgage will depend on how much extra you can afford to pay each month. That is why the Home Mortgage Calculator is set up to let you enter the extra payment amount rather than how many years you want to knock off. However, you can just iterate (change the inputs to check the results) to figure out how you could reach your 15-year or 20-year payoff goal. Hint: If you are using Excel, you might want to try out the built-in Goal Seek tool.
4. Pay As Much as You Can Whenever You Can
Making unscheduled extra principal payments is great. In recent years, this method has received a fancy name: "debt snowflaking." Some people (myself included) like to look at these types of extra mortgage payments as an alternative to investing (see this article). If you have a 6% mortgage, and the alternative is to put the money into a 2% CD, the mathematically superior choice is to put the money towards paying off the mortgage.
How much time you can knock of your mortgage depends of course on how much and how frequently you can make extra payments. The Home Mortgage Calculator was designed to let you add these types of unscheduled extra payments and see what effect they'll have.
5. Don't Squander Your Tax Deduction!
If you qualify for the home mortgage interest tax deduction, the tax deduction is NOT income. It is tempting to think of it is as income or a nice windfall if you get the money back in the form of a tax refund, but it is NOT a tax CREDIT. It is simply a "discount" on what you have to pay to the government or a little "money back". Think of it this way ... if I made you pay me $100 each month and at the end of the year I gave you back $200, is that a deal you should be excited to jump into? Let's hope you said no.
So, what I propose is this ... figure out how much of your tax return is due to your mortgage interest deduction and then make an extra yearly payment on your mortgage equivalent to that amount. As you pay down your mortgage, the amount will decrease (because you will be paying less interest and therefore your tax deduction will decrease).
Here is how you would estimate the tax return due to a mortgage interest deduction ...
- Calculate the total interest you will have paid during the year (e.g. $8000)
- Multiply that total by your marginal tax rate (e.g. for the 25% bracket, 0.25*$8000=$2000)
- The result ($2000) is approximately the tax returned for that year.
When I ran a simulation using the Home Mortgage Calculator, I was pleasantly surprised at what I found out. For a 5% rate and a 25% tax bracket, putting the tax return towards the principal each year should reduce a 30-year mortgage by 6.5 years! On the lower extreme, a 4% interest rate for someone in the 15% tax bracket would knock off about 3.5 years. If you are in a high tax bracket and/or have a high interest rate, you would do well to not squander your tax return.
6. Demolish a Year of Your MortgageAlan Atack, author of The Thinking Man's Mortgage talks about quite a few different mortgage-payoff strategies (for the New Zealand audience). I worked with him on the creation of a New Zealand version of the home mortgage calculator, which he uses in the book to demonstrate some of the strategies. When I read the final draft I was pleasantly surprised to learn a very interesting new strategy. Mentioning this strategy was actually the motivation for writing this entire article.
Alan has a chapter in his book titled "Demolish a Year off Your Mortgage" where he shows how to plan extra payments that will let you reduce your mortgage by one year. I really like this approach, because it helps you set a series of smaller goals instead of just one very long-term goal. Like most debt reduction strategies, it's more about willpower than about the math. The more often you can feel that sense of accomplishment, the more likely you are to keep up the motivation to reach your final goal.
"...take some time to celebrate this achievement with a bottle of bubbly and a special dinner, or perhaps a barbeque for friends and family. Do this every time that you manage to write off a year; it is indeed cause for celebration." - Alan Atack
7. Cut Back On Expenses
This should be obvious, but to make larger extra payments may require you to cut back on your other expenses. Do you really use that gym membership? Are there other "luxury" expenses that you could easily do without for a while?
8. The Last Step In Your Debt Snowball
If paying off your mortgage is just the last hurdle in your quest to become debt-free, you may have already made significant budget cuts to help you pay off credit cards or other loans. Take advantage of the willpower and motivation that it has taken to get to this point and apply your entire snowball towards your mortgage.
If you have more than one mortgage on your home, pay off the one with the lower balance first, simply for the psychological effect that will have.
If refinancing allows you to significantly reduce your interest rate, it might be worth looking into. One of the main considerations is whether you will be in the home long enough to see the benefit, due to the refinance closing costs (which might be around $4000).
With a lower interest rate, your required total monthly payment will be less (assuming you don't change the term of the loan). If you increase your extra principal payments so that you are paying the same total as before the refinance, then you may be able to shave a few years off the mortgage.
Make sure to run plenty of simulations if you decide to go this route, and don't forget to account for the time-value of the closing costs. Although some costs may be paid out-of-pocket, for the sake of simulation you might increase the loan amount by the amount of the closing costs.
10-a. Using an Offset Mortgage Account
An Offset Mortgage is a type of mortgage offered only in some countries and by some banks, where a non-interest bearing savings account (the "offset account") is linked to a mortgage account. When the interest is calculated on the mortgage, the principal on the mortgage is offset by the balance of the savings account. For example, if you owe 100,000 on your mortgage and your offset account has a balance of 20,000, then the interest is calculated based on 100,000-20,000=80,000.
Adding money to the offset account is almost exactly the same (mathematically) as making regular extra principal payments. But, instead of paying down the mortgage directly, you deposit your extra payments into the offset account.
The primary benefit is that you maintain liquidity, meaning that you can withdraw the money from your savings account if you need to.
This may benefit people who currently have a lot of savings and want their savings to be doing more than just earning the mediocre 1% that a normal savings account might earn. By putting savings into the offset account, they can still have access to the money when it is needed, but it's like the offset account is earning tax-free interest at the same rate as the mortgage. Of course, the difference is that rather than earning interest, the offset account is used to reduce the amount of interest you pay.
An offset mortgage has a couple of drawbacks (because otherwise it would sound too good to be true). The interest rate tends to be higher than the normal mortgage, may be variable rate rather than fixed rate, and there may be an annual fee. If you are only looking for a way to preserve liquidity when making extra payments, then you might look for a lower-rate mortgage that offers redraws.
Although I currently don't have a spreadsheet specifically for an offset mortgage, you can simulate the approach by making extra payments with the Home Mortgage Calculator.
Direct-Depositing Your Paycheck Into the Offset Account
One way to keep the offset account balance as high as possible is to (1) direct-deposit your paycheck into the account and (2) pay expenses using a credit card, making sure to pay off the credit card in full each month (assuming that your credit card charges zero interest if you pay it off fully each month). You may be able to set up an automatic payment to pay off the credit card each month so that you can avoid the fees and interest from forgetting to pay your bill.
IMPORTANT: This only works if you earn more than you spend.
Just like with any liquid savings account, you may be tempted to spend your savings on a whim or unnecessary luxury item. You may want to reduce this temptation by making an occasional extra payment on your mortgage, rather than running up a huge balance in your offset account.
10-b. Using a Line of Credit as an Offset Account
This method is often promoted when an offset savings account discussed in 10-a is not an option and a person wants to maintain some liquidity or employ the "Direct-Depositing Your Paycheck Into the Offset Account" technique mentioned above. It involves using a line of credit, such as a HELOC (Home Equity Line of Credit) or PLOC (Personal Line of Credit). If you don't have sufficient home equity, you probably won't qualify for a HELOC, but a PLOC might be an option.
I'm not talking about refinancing your first lien mortgage as a HELOC. Instead, in this scenario, a person would be using a separate line of credit like a second mortgage. Unlike an Offset Savings Account, a line of credit charges interest. A HELOC is also variable rate, so you don't want to expose your entire mortgage to the risk of a variable rate (at least not during a period where the rate is expected to increase). That is why you use a separate HELOC instead of refinancing the primary mortgage.
The Line of Credit method involves repeating 3 main steps.
1. Transferring the Balance
When using the HELOC, you would transfer $10,000 (just an example) from the HELOC to the Mortgage. This would reduce the mortgage principal by $10,000, but increase the amount owed in the HELOC by $10000. If the rates were the same for the mortgage and the HELOC, there would be no real difference (still paying the same amount of interest each month). However, the idea is to make extra payments toward the HELOC instead of the mortgage, so that you maintain some liquidity (the ability to pull cash back out of the HELOC if necessary).
2. Parking the Paycheck and Paying Bills (optional)
At the beginning of the month, your $5000 paycheck (again, just an example) is deposited into the HELOC. You might choose to pay bills with a credit card to take advantage of the 30-day grace period on the credit card. Then, at the end of the month, you pay off the balance on the credit card using the HELOC. If your expenses are $5000, then the only benefit you gain from this approach is the $5000 offset. If you make other payments from your HELOC throughout the month, then the benefit is even less. This step is unnecessary, complicated, risky, and provides little extra benefit, so I don't like it.
3. Paying off the HELOC
If you are using Step 2 and your paycheck is $5000 and your expenses are $4000, then this approach automatically applies 100% of your free cash flow ($1000) toward paying down the HELOC balance, which will be $9000 at the end of the month. Alternatively, if you skip Step 2, you can make the monthly extra payment of $1000 to the HELOC. If you continue this for 10 months, the balance of the HELOC will be $0. When the HELOC balance drops to $0, you can return to step 1 and transfer another $10000 from your HELOC to the mortgage.
Here are a few disadvantages to the line of credit approach:
- HELOCs are variable rate and may be a higher rate than your mortgage
- There is a risk of your HELOC account freezing (meaning that you cannot pull any more cash out). If you are relying on that to pay bills, that could put you in a bad situation.
- You take a big risk of getting into worse debt if you are not extremely careful about watching your spending.
- It's complicated, over-hyped, and often misrepresented (especially the part about parking your paycheck).
A company may try to get you to purchase some expensive software that can help you keep track of your HELOC account, tell you when to make transfers, and tell you how much to transfer based on relative interest rates, etc. But, what they don't usually explain (or explain incorrectly) is that almost all of the payoff acceleration with the line of credit approach comes from making extra payments on the principal using that extra $1000/month. Compared to that, the benefit of parking your paycheck and paying bills from the HELOC is pretty small.
Consider this scenario
Bob has a fixed 5%, 25-year, $100,000 mortgage. On average, Bob earns $3000/month and spends $2750/month. If Bob uses his free cash flow of $250 to make an extra principal payment each month, what is the maximum benefit that can come from parking his paycheck and paying his bills from the HELOC?
First of all, making the $250 extra payment each month will end up reducing the total interest cost by $36,551 (this also results in the mortgage being paid off 11 years early). Bob does this by setting up an automatic extra principal payment each month, a nice feature offered by his mortgage lender.
Parking $2750 in the HELOC acts as an offset to the mortgage. An offset of $2750 can be simulated as a one-time $2750 extra payment, so this would end up reducing the total interest cost by another $2421. But that's it. Bob would have spent about 14 years messing with Step 2 of the HELOC approach, only to avoid paying another $2421 in interest.
Consider skipping Step 2
One of the advantages of using the HELOC approach is liquidity - the ability to pull money out when you want it. If you make an extra principal payment on your primary mortgage, that cash becomes unavailable. But, if you use your free cash flow to make payments on the HELOC, you will still have access to that cash (assuming your account doesn't get frozen).
So, if you don't like the risk of parking your paycheck, but you like the idea of the liquidity that a HELOC provides, skip step 2 and use your extra cash flow to make extra payments on the HELOC balance.
I like the idea of making extra principal payments on a mortgage as an alternative to investing, but I'm not a fan of going to the extreme of parking my paycheck in a HELOC.
Remember! Mortgage acceleration is about paying down the principal. If there is a way to reduce the interest rate or the basis for calculating interest, that can help, but it needs to be combined with making larger payments on the principal.