A frequently-asked question is whether a mortgage borrower receives any benefit from paying before the due date. In most cases, the answer is ânoâ, but there are a few exceptions. When you pay off a simple interest mortgage, like a home equity line of credit (HELOC), early payment does save you money. In some cases, paying early to move next year’s interest into this year could even lower your taxes.
It might seem like a good idea to pay off your mortgage early. Surely, the faster you pay off your home loan, the less interest you’ll have to pay over the loan’s life? Alas, it’s not quite that easy. Different types of mortgages have different rules about whether paying your loan early will save you money.
How Mortgage Interest Works
With a standard fixed-rate mortgage, interest is calculated on a monthly basis. Your monthly mortgage payment is applied to interest first, and any remaining amount goes toward the principal (the amount you originally borrowed).
Each month, interest accrues based on the unpaid principal balance. If you pay more than the minimum each month, the lender will apply the extra money to the principal, lowering your balance. You can make an early payment, but that doesn’t change the amount of interest you owe that month because it was already set.
Essentially, by making additional payments throughout the month, you are letting the lender use your money interest-free until the scheduled payment date. While you will pay off your loan faster by making extra payments, it won’t save you money on interest with a standard mortgage.
When Extra Payments Do Save Interest
Certain types of mortgages do give you interest savings for early payments
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Simple interest mortgages – With these, interest accrues daily rather than monthly. An early payment reduces the interest you owe for the remaining days of the month.
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Some types of home equity lines of credit (HELOCs) also use simple interest, which means that making extra payments can lower the total amount of interest you pay.
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ARMs – Adjustable-rate mortgages (ARMs) recalculate your monthly payment when the interest rate changes. Additional payments before a rate hike can reduce interest at the higher rate.
While early payments on standard fixed-rate mortgages don’t directly save interest, they have other benefits:
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You’ll pay off your loan faster and own your home sooner.
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Additional payments give you a cushion if you ever have trouble making your regular payment.
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You’ll have more equity in your home.
Strategies for Early Payment
If you want to pay your fixed-rate mortgage ahead of schedule, here are a few options:
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Make one extra payment each year. This adds up over the life of the loan without significantly impacting your monthly budget.
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Split your monthly payment in two and pay half mid-month. This means the lender doesn’t have to wait as long to get the extra money.
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Recast your loan after making a lump-sum payment. The lender recalculates your payment based on the lower balance. This keeps your monthly payment the same but helps you pay off the loan faster.
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Refinance to a shorter term. You’ll have higher monthly payments but pay off the balance sooner.
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Discuss bi-weekly payments with your lender. An automatic debit every two weeks divides your monthly payment amount into 26 partial payments per year, giving you the effect of one extra monthly payment annually. Not all lenders offer this option.
The bottom line is that while early payments on a standard fixed mortgage won’t directly reduce interest costs, they can still be a sound strategy for paying off your home faster. Just be sure you have a sufficient emergency fund and are able to make the higher payments comfortably.
Are There Other Benefits to Paying Early?
Aside from the interest savings on certain types of loans, early mortgage payments can provide other advantages:
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Paying ahead for future payments – Make sure your lender only cashes the checks on the scheduled due dates so you don’t give them an interest-free loan.
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Tax benefits – Paying January’s mortgage payment in December shifts interest to the current tax year if you itemize deductions. This could help lower your tax bill if your income is higher this year.
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Avoiding late fees – Paying early provides a cushion in case unexpected events cause a late payment. Late fees and damage to your credit are expensive downsides to delayed payments.
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Equity and savings – The more extra payments you make, the faster you build equity. This gives you savings and borrowing power for other financial goals.
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Peace of mind – Eliminating a mortgage early provides financial freedom and flexibility. The security of owning your home free and clear is comforting.
The Final Word on Prepayment
Paying your fixed-rate mortgage early does not directly lower interest costs, but it allows you to pay off your home faster. This can free up cash flow in retirement, provide equity for other needs, and give you peace of mind. Just be sure you fully understand the terms of your specific home loan before choosing a payment strategy.
Simple interest loans like HELOCs do give you interest savings for early payments. But otherwise, view extra payments as a way to pay off your mortgage faster, not reduce interest. The real savings come from eliminating years of payments on the back end by putting in a little extra effort on the front end.
Simple Interest Mortgages Are Different
On simple interest mortgages, interest accrues daily rather than monthly, which changes the rules significantly. As with standard mortgages, payments are due on the first day of the month and late fees are charged on payments received after the grace period. On simple interest mortgages, however, interest is due every day. This means that a borrower who pays one day late pays additional interest for that day, and the borrower who pays one day early saves a dayâs interest.
The bottom line is that a borrower who consistently pays 2 weeks early will save money on a simple interest mortgage. That doesnât bother the lenders because they know that those are rare birds. Most borrowers pay late.
Borrowers donât get to choose between standard and simple interest mortgages; I have never heard of it being offered as an option. Most have standard mortgages, and those with simple interest mortgages typically didnât know what they were getting. Borrowers need to adapt their payment habits to the kind of mortgage that they have.
I should note that HELOCs are simple interest and most HELOC borrowers do understand that they accrue interest daily. It pays to pay early on a HELOC.
When Payments Are Early
Payments made before the due date are also credited as of that date. This gives the lender free use of the borrowerâs money for that period. The borrower who consistently pays two weeks early, for example, is in effect providing the lender with a two-week grace period comparable to that provided by the lender to borrowers who pay late. There is no benefit to the borrower.
Pros and Cons of a Bi-weekly Mortgage Payment | Is this for you?
FAQ
Is it good to pay your mortgage before the due date?
Indeed, if you pay your mortgage off a day early, you avoid having to pay interest on that day, which can add up over time.
Do you save money if you pay your mortgage early?
You can save a lot of money on interest and use that extra money to reach other goals if you pay off your mortgage early.
What is the 2% rule for mortgage payoff?
If you want to pay off your mortgage quickly, the 20%222% rule says to try to get a new interest rate that is 2% lower than your current rate. This helps ensure that the savings generated by refinancing outweigh the costs associated with it.
Is there a downside to paying off a mortgage early?