Thirty-year mortgage loans are common, but many people will try to pay extra each month to pay off their house early. The ultimate question is whether it is a good idea to try to pay off your mortgage faster or would you benefit more using that money elsewhere?
It can actually be pretty easy to get blinded by trying to own your home outright. Own your house may be a lifelong dream that makes you feel successful. However, certain situations could make paying off your mortgage early bad for your overall financial situation.
The biggest advantage of paying off your house early is that you avoid paying interest. Let's examine a hypothetical scenario. You buy a house and finance $300,000 of the purchase price. At 3% APR you will pay $455,332.36 total with a 30-year mortgage, so you pay $155,332.36 in interest over those 30 years. The monthly payment on that loan is $1,264.81.
What if you decide to pay extra each month? If you pay $2,483.36 each month ($1,218.55 extra, almost a double payment), you'll pay off the loan in 12 years. At this increased payment rate, you'd only pay $357,603.85 total on the loan - just $57,603.85 interest. That's almost $100k in interest savings to buy your house in full.
The savings are even more substantial when you have a higher interest rate on your mortgage. Buying the same house as before but with a 6% APR, you'll pay $647,514.57 total with monthly payments of $1,798.65. That's almost $200k extra interest costs simply because of the higher rate. To pay off that loan in 12 years you would need to pay $2,927.55 each month. You'd still pay $421,567.29 total for the house. In this scenario, paying off the house early saves you almost $226,000 in interest! As you can see, your savings will vary drastically depending on your loan APR.
Even though the interest savings can be substantial, some people want to pay off their mortgage early for the psychological effect of completely owning your home. It can feel great to not make a rent or mortgage payment each month and give you a sense of housing security since you can never experience a foreclosure with the bank.
One thing to keep in mind, in the United States at least, is that you'll never truly own your home outright without the need to make monthly payments. You can eliminate a mortgage payment completely, but you will always have to pay property taxes or else you can still lose the house. Insurance costs can be stopped once you finish your mortgage, but it's often a good idea to continue paying them too.
Despite the fact that you can never completely get away from monthly payments on your house, paying off the mortgage can still be a huge mental win for you and encouragement to pay it off faster. There's nothing wrong with trying to have your mortgage paid off before you hit retirement age to reduce your monthly costs to make it more feasible to live on a lower income.
Average Investment Returns
One of the major factors you need to consider before contributing extra money towards your house payment each month is how much you could make investing that money instead. Let's revisit my examples from the interest savings calculations.
For 3% home loan, it took an extra $1,218 per month to pay off the 30-year loan in 12 years. That saved $97,728.51 in interest. What if you invested that $1218 per month into an S&P500 index fund instead? Over the past 10 years, the S&P500 has averaged 13.95% returns. Using that rate, $1218 invested each month for 12 years would yield $455,099 total at the end of those 12 years. That even drastically beats the $226,000 in interest savings from paying off the 6% APR loan early!
The point here is that the extra cash that you spend on the mortgage each month to pay it off early may be able to make more money for you if you invest it. Saving $100k or $200k on your mortgage doesn't matter if that same money invested would give you $455k. In general, if your investment returns are higher than your mortgage APR, invest the money instead of paying off your house early.
Effects on Credit Score
Everyone talks about the money you can save on interest by paying off your house early, but they don't usually discuss another important factor for me. I'm talking about your credit score. You would think that paying off a long-term, high dollar value loan would be great for your credit rating. However, closing out your mortgage can actually have the opposite effect.
Having a mixture of types of credit is one factor to your credit score. When you pay off your mortgage, you no longer have that type of credit on your report anymore. You also lose the benefits of making an on-time payment each month.
In addition to losing a mixture of credit types, you also lose a loan with a long lifespan. Older credit accounts score better, and the average age of accounts on your credit report overall is another score factor. Your average account age will usually decrease when the house loan is paid in full. As a result of all of these factors combined, you'll likely experience an immediate credit score drop that could be 30-60 points, once you finally pay off your mortgage!
In this regard, you'd actually benefit more by keeping this loan active for a longer period of time. This can especially be true since most people are unlikely to take out another mortgage if their goal was to pay off their house and live without a monthly payment for the rest of their life.
Should You Pay Off Your Mortgage Early?
With all of this knowledge, you should be able to make a more educated decision now about whether you should pay off your mortgage early or invest the extra cash instead. If you can get a better rate of return investing extra money, you would benefit more financially by investing extra money. However, your risk tolerance and desire to own a fully paid home may outweigh the potential financial benefits.
Anyone that was able to obtain a mortgage during the COVID pandemic has a really low APR. I was able to get 3% but some people got even less than that. In that situation, you're much more likely to benefit more from investing extra cash. If you have an older mortgage with a high rate or you obtain a mortgage from mid-2022 until rates go back down, it's possible you could benefit more by paying off your house early.
One final thing to consider is inflation. You may pay $2,000 a month on your new residence and consider that to be a lot of money. However, this will likely not be the case in 30 years. Over time inflation will eat away at the purchasing power of each dollar. In 30 years, a monthly payment of $2k per month will be like having a house payment of only $953 today. This simply means that the longer you keep your mortgage payment, the more affordable that monthly payment will become over the life of the loan.