Paying off a mortgage in five years is a great idea. Usually, that's only possible when you're more than halfway through your existing mortgage, however. But even when you can't do it in five, shortening the payback period makes a dramatic difference in the total amount of interest you pay on the loan. Being strategic about how you go about it, however, is important. Some ways of paying off a mortgage early are better than others.
Paying Off Your Mortgage in Five Years
Nearly 90 percent of home buyers choose a 30-year fixed rate mortgage when they're buying a home. Only 2 percent of home buyers still go for an adjustable rate mortgage (ARM), where the interest rate goes up or down in response to some external standard, like the prime rate banks charge their largest established corporate clients. A couple of really painful rate increases in ARMS over the past few decades have steered most buyers away from variable rate loans, so much so that many smaller banking institutions no longer even offer them to residential buyers.
So, chances are good that you have a 30-year fixed rate mortgage. How much you'll save by paying it off in five years instead of the scheduled 30 is impressive. If you've got a 30-year mortgage of, say, $400,000, and you're paying 4 percent interest, paying it off as scheduled will cost you just a little under $288,000 in interest. If, on the other hand, you pay the same loan off in five years instead, your total interest is only $41,996, a savings of nearly $250,000. There are a number of ways of doing this, some better than others. While none of them individually, or even employed together, will convert a young 30-year mortgage to a 5-year payout schedule, they will shorten the payback term dramatically and, if you're somewhere past the middle of a 30-year, then, yes, employing several of these strategies could mean a payoff in just five years. At which point, champagne and cake for everyone!
Tips for Paying Off Your Mortgage Sooner Than Later
Refi with a shorter term loan. In reality, you could save even more than $250,000 in interest charges simply by refinancing for a shorter term (although, when doing this be very careful about the refi fees). Shorter-term mortgages almost always offer lower interest rates. For instance, today's Quicken fixed loan rate for a 30-year $400,000 mortgage with good credit and a 20 percent down payment is 4.5 percent; the same lender offers a 3.99 rate for a 15-year fixed and a 3.75 rate for an 8-year fixed. No major lenders offer 5-year mortgages. But even if they did, refinancing a relatively recent 30-year to a 5-year might not be the best idea; once you've committed to that rate, you're stuck with it unless you refi. The payments, even with a slightly lower interest rate, can be daunting. The payments on that $400,000 Quicken loan exclusive of taxes, insurance and fees, are $2,026 per month for a 30-year, $2,956 per month for a 15-year and $4,646 per month for an 8-year. Unless you're very certain of a continued high income far into the future, you'd probably be better off with the 15-year loan, which increases payments by a little under half, rather than the 8-year, which more than doubles it, especially since you achieve the greater rate reduction – more than a half-point – by dropping from a 30-year to a 15-year. Dropping to the 8-year reduces your rate by less than an additional quarter-point.
Change your payment schedule. If you change your payment schedule from the usual one payment a month to one half-payment every two weeks, your loan will pay off measurably faster. Instead of a total of 12 payments a year (once monthly), you're now paying 26 half-payments, which means that every year you're paying off an additional payment equal to your former monthly payment. This strategy alone converts a 15-year loan to a 13.6-year loan and on that $400,000 Quicken loan, it saves you more than $15,000 in interest. Many large loan servicers today, Quicken among them, are already set up to do this, so switching is pretty easy. It doesn't involve taking out a new loan; in most cases, where you already have an escrow account set up for automatic payment deductions, you simply notify your lender that you want to change the schedule. There's no charge for this. Just remember to include that extra amount each month in your budget.
Make an extra payment each year. This strategy is similar to changing your payment schedule and works best when you make that extra payment in January. This reduces the balance outstanding on every subsequent payment, meaning that more money goes to principal and less to interest all through the year. When you make the extra payment in January or February, the total savings and loan period reduction are similar to those you achieve with the bi-weekly payment play.
Drop your Private Mortgage Insurance (PMI). When you buy a house with less than 20 percent down, the lender may require you to obtain PMI. Unlike your home insurance, this really doesn't benefit you at all; it's insurance for your lender in the event that you default on the loan. Few lenders will tell you this, but once you've paid down the loan sufficiently so that you've got at least 80 percent equity, you have the right to drop PMI insurance. You don't necessarily have to make payments sufficient to get to 80 percent equity either; with an appraisal that shows sufficient increase in the value of your house, you can petition the lender to drop the insurance. With most mortgages, the savings range from $50 to $200 each month. If you continue your earlier payment schedule, with that additional amount going toward principal, eventually it'll make a significant difference.
Refinance at a lower rate. In 2010, the economy began its long recovery from "the Great Recession." One of the means the government employed to help the recovery was to drop interest rates to historical lows. Many homeowners were able to refi older mortgages with rates of 6 percent or more to new loans with rates as low as 3.25 percent. This had multiple effects, some good, some bad (it greatly contributed to the rapid increase in housing costs), but the greatest single benefit was to homeowners who had interest rates cut in half. Unfortunately, in 2018 interest rates are rising again. However, if you haven't refinanced yet and still have one of these older loans with rates above 4 percent, you can still achieve considerable savings by refi-ing.
Create a household reserve fund and whenever it reaches a certain level, pay part of the reserve toward your mortgage. It's prudent to set up a household reserve fund, even aside from the possible mortgage savings. When your family sets aside a certain amount each month for emergencies, uninsured medical expenses and other emergencies and you pay into that fund regularly, at some point you'll have as much as six month's living expenses in the fund – a level that most financial advisors recommend, although few homeowners manage to achieve it. If you're one of the disciplined few, however, when the amount goes over the six-month reserve amount, use the surplus to pay down your mortgage. A similar strategy is to take advantage of bonuses or other unexpected sources of income to pay down the mortgage. Your first impulse may be to celebrate, and sometimes that's probably the right thing to do. But at other times, you'll benefit more from a bonus mortgage payment that achieves interest savings every month from that point on.