If you are interested in getting completely out of debt, paying off your mortgage may be the largest hurdle. Here is a list of the strategies for paying off your mortgage early. All of these strategies can be evaluated using the free Home Mortgage Calculator spreadsheet. Instead of talking about how much you might save by paying off your mortgage early, I'm going to talk about how many years each method can knock off.
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. We're going to assume for these examples that you have a fixed-rate mortgage, because if you have a HEL (home equity loan), HELOC (home equity line of credit), or ARM (adjustable-rate mortgage), things can be a little different. However, paying off a loan always comes down to having to pay the principal, no matter what type of debt you have. (We're going to assume for this article that foreclosure and bankruptcy are not options you want to consider).
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 vs. monthly does almost nothing to help you. It is the "accelerated" part 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|
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. If you have a 6% mortgage, and the alternative is to put the money into a 4% 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 a more than one mortgage on your home, pay off the one with the lower balance first, simply for the psychological effect that will have.
9. Refinance (maybe)
If refinancing could lead to a significantly reduced interest rate, it might be worth looking into. With a lower interest rate, your monthly payment would likely go down and therefore you could afford to make a larger extra payment.
The problem is that people usually try to refinance to reduce their monthly payment. If you have already been aggressively paying down a mortgage, you may find that refinancing is not necessarily going to help much.
There are a lot of variables associated with refinancing, so make sure to run plenty of simulations if you decide to go this route.
10. Converting to a HELOC
This method (known also as an "Australian Mortgage") is often promoted by companies that use high-powered sales speak like "pay off your mortgage in lightning speed." The idea is to direct-deposit your entire paycheck into your special revolving line of credit account and then pay all your bills from there. A company may try to get you to purchase some expensive software that can help you keep track of your HELOC account. The cost of the software is probably the reason that I've received so many requests for creating a spreadsheet to manage this type of plan (which I refuse to do, by the way).
In theory, the idea makes sense: Instead of having a checking account balance just sitting around doing nothing, that balance could be helping to reduce the interest owed on your mortgage.
However, I don't like this approach because the main reason for paying off your mortgage is to REDUCE risk and REDUCE stress. This approach actually INCREASES risk because if you don't watch your spending very carefully, you could end up getting deeper into debt. There is also the risk that credit accounts may be frozen (meaning you wouldn't be able to make additional withdrawals - a reason to avoid throwing your emergency fund into the mix). This approach encourages the use of credit accounts, which may be exactly the type of habit you are trying to break.
Most of the payoff acceleration with this line-of-credit approach still comes from making extra payments on the principal, which you can do easily (with no software or fees) using some of the other methods mentioned above. The additional benefit of an Australian Mortgage is the idea that instead of your checking account earning no interest, it could be earning interest at a rate similar to the mortgage rate.
A lower risk alternative to the HELOC approach would be to look for a high-yield checking account so that you can be earning interest on your checking balance (and use other methods to make extra principal payments).
In general, you should be suspicious of anything heavily advertised. Make sure you understand and weigh the risks.