A Helpful Guide to Early Mortgage Payoff
Have you been making your monthly mortgage payments for the past few years and want to know how far along you are on the journey to paying off your home? Well, that's a question a lot of homeowners have. Sure you can pull out the amortization schedule that's buried deep down inside your mortgage paperwork and see where you are at any given time. But that doesn't really give you the whole picture, now does it? What if you want to accelerate your payments or refinance your home? How do those situations affect your payoff date?
In this quick, helpful guide, I'm going to go over a few of the options you have for paying off your mortgage early and some of the pitfalls you might run into along the way. By the time were done, you should have a much clearer picture of where you are and what it will take to get your home paid off early. So, grab a cup of your favorite beverage and a notepad and let's get started.
Understanding Your Mortgage Payment Breakdown
The first thing we'll tackle is how each of your mortgage payments is broken down. Every one of your mortgage payments includes four parts which are commonly known as PITI: Principal, Interest, Taxes, and Insurance.
The Principal is the amount of money you owe on your mortgage. If you take out a $100,000 mortgage then the Principal is $100,000. It's that simple. Each of your payments reduces the total amount owed by a certain amount with very little of the first payments making a dent in it. As time goes by, more and more of each monthly payment goes towards the principal until it makes up the majority of your final payments. If you refinance your loan, this cycle starts over again. (See the 50/25 Rule below)
A portion of each mortgage payment goes towards interest on your loan with the bulk of your first payments going towards interest. As time goes by and your principal gets paid down, the amount of interest in each of your monthly payments reduces until most of your last payments are principal and hardly any of it is interest. Once again, if you refinance your loan, this cycle starts over again. (See the 50/25 Rule below)
For the most part, the portion of your monthly mortgage payment that goes towards taxes doesn't change unless your local government either changes the tax rate or they reassess your property's taxable value. This can also change if you make substantial changes to your home such as adding an addition, a garage, or a swimming pool.
Like taxes, the portion of your monthly mortgage payment that goes towards insurance doesn't change unless your change your coverage. It can also change if you have made any claims against your homeowner's policy.
The 50/25 Rule
Basically the 50/25 Rule says that after you make the first 50% of your mortgage payments, you've only paid off around 25% of the total balance owed. This means that if you took out a 30-year $100,000 mortgage, after you've been paying on it for 15 years (50% of the payments), you've only paid down around $25,000 (i.e. 25%) of the balance, still owing $75,000. This is because of the way mortgage payments are structured.
For most mortgages, the first payments are made up almost exclusively of interest with very little going towards principal (something like 95-plus percent of each payment excluding the fixed taxes and insurance part we talked about above). As time goes by, each succeeding payment has a little bit less interest in it and a little bit more principal until your last few payments are almost entirely made up of principal (once again except for the taxes and insurance). This is why after years of paying your monthly mortgage payments you end up still owing a lot of money to the bank. Some people believe that refinancing their mortgage at a lower interest rate will help them pay off their balance quicker but this can backfire on them if they're not careful.
How Refinancing Your Home Affects Your Payoff Date
Many homeowners look at the interest they're paying on their mortgage and wonder if finding a lower rate would save them money. Well, the answer might not be as clear and simple at you would think. Here are a few things to consider before refinancing your home.
How much is the interest rate really going to save you over time?
There are numerous calculators you can use to figure out the total amount of interest you'll be paying over the life of your mortgage. (Personally I like to use DinkyTown.) Use one of them to get the overall interest you'll be paying at your current interest rate and then get the same figure for the new interest rate. Many times the difference is only a few hundred dollars over the course of a 30-year mortgage. Before you make the leap, make sure that the closing costs of the new loan (see below) make it worth your time and energy.
What are the closing costs on the new loan and how do you plan to pay them?
Whenever you refinance your home mortgage, there are always costs involved. After all, it makes sense that the bank wants to get paid for processing the paperwork and managing the payments, right? So, do you know how the closing costs on the new loan are going to affect your bottom line? Generally they're either rolled into the new balance or you pay for them up front? If they're rolled into the new mortgage, you'll be paying interest on the increased balance which can affect your overall cost. This often happens when you don't have the entire amount (which can be in the thousands of dollars) up front. Many times the choice comes down to your overall financial picture and if paying the closing costs up front with stress your finances in the short term.
How much longer are you going to have to pay on your existing mortgage?
Remember the 50/25 Rule we talked about earlier? If you've been paying on your existing mortgage for a number of years, you'll be starting all over again with the majority of each monthly payment going towards interest. Is that something you really want? Using a mortgage calculator can usually tell you if it will be worth your while to refinance with a lower interest rate or if continuing on with your current rate will actually save you money.
Something else to consider is your peace of mind. Having a paid off home can be very satisfying as well as financially advantageous. Without a mortgage payment every month, you can be investing that money month after month and year after year and accumulate a huge nest egg over time.
How Making Bi-weekly Mortgage Payments Can Help You Pay Off Your Mortgage Quicker
The last thing I want to cover in this guide is the Bi-Weekly Mortgage Payment. This type of mortgage payment structure has gained popularity in recent years and comes with its share of fans and critics. Basically it's a way to accelerate the payment of your mortgage by several years and is designed to save you money in overall interest paid. Here's how it works.
Basically, instead of paying one mortgage payment every month, you pay half your normal mortgage payment every two weeks. This ends up with you paying a total of 26 half-payments each year instead of 12 full payments. While this might not seem like a huge difference, if set up the right way, it can actually allow you to get your 30-year mortgage paid off in only about 25 years and save you a good amount of interest as well. However, there are some things to consider before going down that path.
- Can allow you to pay off your mortgage earlier (about 25 years vs 30 years)
- Saves you money on the overall interest you'll pay over the life of your mortgage
- Can accelerate building up your equity in the home and reduce the amount of time you need to pay PMI (private mortgage insurance)
- Depending on the mortgage company, sometimes they'll hold the first half of the mortgage payment until they get the second half before applying the payments to the outstanding balance. This lets them use your money for two weeks every month interest free. It also lets the loan accrue interest for those two weeks on the outstanding balance instead of immediately reducing the amount owed which the interest is based on.
- Depending on the mortgage company, sometimes they'll charge a fee to set up this type of payment plan and/or charge you a monthly fee every time you make a payment. This is so that they can recoup the lost interest they were expecting to receive over the entire 30-year mortgage rather than the 25 years you actually end up paying for.
Putting it all Together
Well guys, I hope this quick guide to paying off your mortgage early helps you get some clarity on the ins and outs of your mortgage. I've given you some of the basics you'll need in order to make an informed decision on whether or not refinancing your home is the right choice for you. Just remember, no one cares more about your money than you do and so do your research, get educated, and get empowered!
Thanks for reading!