We are used to the fact that mortgages are for a long time. But can you try to pay earlier? Especially if your income has suddenly increased (or not suddenly). In this article, we describe the pros and cons of early mortgage repayment and also answer the question of when it is worth trying to do this.
What is an early loan repayment?
Early repayment of a loan is a voluntary payment by the borrower of the loan debt balance ahead of the schedule stipulated by the agreement.
Most often, people pay off their mortgage early in such cases: when incomes suddenly increase, when receiving an inheritance, and selling other real or movable property. You can deposit funds in parts (every month, once a year) or in a lump sum in full. But, of course, early repayment has pros and cons – let’s look at a few of them.
Main benefit: less overpayment on interest
Early repayment of a loan has only one plus, but it covers all the numerous minuses. This way is good because it allows you to save on interest payments that accrue over the entire term of the loan.
For example, at the end of the payment period, someone who took out a mortgage for 30 years will overpay more than twice concerning the principal debt. Obviously, the difference goes to paying interest.
Therefore, early repayment of the loan is beneficial, especially in the early years. This means that the debtor will pay for the property faster and spend less money on paying interest.
For example, a borrower takes $200,000 at 7% interest for 30 years. By paying an additional $50 each month, he saves $36,427 over the life of the loan.
The sooner you start investing additional funds, the less interest will be charged over the remaining term of the loan, and the more you will save.
Inflation favors the borrower, and early repayment means paying more for the loan. However, it is believed that if the growth rate in mortgage rates outstrips the inflation rate, then it is profitable to repay the loan ahead of schedule.
For example, if inflation is 3%, the mortgage rate is 5%, but an investor can only get a 10% loan from a bank for his business. A businessman should expand the credit line and invest this money in circulation. It all depends on your specific situation.
Early loan repayment is unprofitable for banks, as they lose part of the profit and recalculate interest, which adds work to employees. Therefore, banks often impose penalties for early payments. In most cases, such penalties threaten only those who pay more than 20% of the debt in the first five years (in some banks – in one year).
Depending on the bank, the early repayment penalty is 1-3%.
How much will you have to pay?
Penalties may vary, but there are several ways to determine a possible fine:
Percentage of the loan balance
Typically, the lender will charge a small percentage of the principal amount of the loan as a penalty. Provided that the payment occurs in the first 2-3 years of the term.
Number of months of interest
In this case, the borrower pays a certain number of months of interest.
Sliding scale based on mortgage term
This model is considered more common. For example, if you decide to pay off your mortgage during the first year, the penalty will be 2% of the principal debt. If during the second – 1% of the outstanding debt.
Banks set a period before the expiration of which the borrower must notify the early repayment. Most often, advance payments are allowed 30–90 days after the start of lending. The maximum notice period is six months.
Lesser tax breaks
There are tax breaks in the US for those who pay a mortgage. The higher the percentage, the greater the benefit. Those who repay the loan ahead of schedule are partly deprived of these privileges. But in return, they receive tens of thousands of dollars saved through early payments.
For example, a borrower takes a mortgage in the US for $200,000 for 30 years at 6% per annum. In this case, he will overpay almost $28,300 in interest. If the borrower pays federal tax at a rate of 28%, then in case of early repayment, the net rate of return will be 4.44%.
So when should you pay off your mortgage early?
It all depends on the individual investor and the opportunity cost. If, at the beginning of the mortgage term, an investor can earn 35% of his free money, then, of course, there is no point in paying off the mortgage with this money. If an investor can earn a maximum of 0.5%, then you should consider early repayment. Sometimes inheritance tax plays a decisive role: if there is a mortgage loan, then this tax is lower. So in many cases, wealthy clients do not release real estate from the mortgage.
Early loan repayment. Conclusion
Is paying off your mortgage early a good idea? On the one hand, yes, because it reduces the amount you pay over time. On the other hand, we do not recommend obsessing over paying off the debt as soon as possible.
The extra money can be put into investing, paying off other debts, or putting it into a retirement account — there are many fun ways to make your money work.
The decision to pay off your mortgage early depends on your personal vision of the process and on individual circumstances. In any case, it is always better to consult a professional in order to accurately make an informed and correct decision. Therefore, if you are thinking about paying off your debt early, don’t hesitate to sign up for a consultation where we can find the best solution for your unique situation. We’ll find a payment plan that works for you and your budget, no matter how big or small the debt.