3 Ways to Pay Off Your MortgageThere are endless debates within the personal finance community about whether or not it makes sense to pay off your mortgage faster.  This post doesn’t tackle that question (but I will tackle it in the future).  Instead, this post deals with three different ways to pay off your mortgage, ranging from the most conservative approach to the most aggressive approach.

The basics behind each approach are easy: pay less and your mortgage term lasts longer; pay more and your mortgage term will be shorter.  But each of these approaches lends a structure to your mortgage payoff plan, so you can evaluate your progress and keep on track.  Being able to track your progress is critical to maintaining financial momentum.  Most importantly, each approach ensures that you’re not backsliding on your mortgage balance, or dragging out your loan term beyond what you had initially planned.  There’s virtually no scenario where that makes financial sense, so consider that option off the table.

The Conservative Approach

The conservative approach is the most plain vanilla method you can think of.  It consists of taking out a traditional 30-year loan, and paying it off over 30 years.  Thrilling, right?

If interest rates drop, of course, you can consider refinancing.  Just make sure you only refinance if you get a lower interest rate that makes a meaningful difference (i.e., the interest savings over the life of the loan—or the length of time you plan to live in the house, whichever is shorter—is higher than the cost of refinancing).

If you refinance, do NOT pull any cash out.  The only exception to this rule is if you are going to use the cash proceeds to invest elsewhere.  (Remodeling, buying a new car, or spending the money on something other than income producing property is not investing.)  After you refinance, even if your payment amount drops, calculate what your payments would be to pay off your loan over the same original 30 year term, and make those payments.

Example: In January 2010, you bought a $500,000 house with a $400,000 mortgage, financed at 4.5% interest over 30 years.  As of January 1, 2016, your balance would be $357,241.03.  This is what your loan amortization schedule looks like:  (click to enlarge)

01.20 amortization

(Quick note: the amortization schedules in this post are cropped to show just a few months’ worth of data.  If you would like the full amortization schedule, or if you need help creating your own, contact me.)

Now assume you refinance in January 2016 for another 30 year mortgage at 3.75%.  Your loan payment dropped from $2,026.74 to $1,654.44.  But if you pay the new lower payment, the term of your loan will be extended by another 6 years.  Here’s what your new amortization schedule looks like:  (click to enlarge)

01.20 amortization conservative 2

But instead of paying the smaller payment amount, go into your amortization schedule and bump up the payment until you end up with the same payoff date as your original note, i.e., January 2040.  Otherwise, you would be backsliding.  By paying $1,883.03 per month, you can keep your January 1, 2040 payoff date, and still save $143.71 per month.

The Moderate Approach

Let’s say the conservative approach isn’t enough for you.  Instead of enjoying the lower monthly payments, you want to apply your interest savings toward the principal amount of the loan, to accelerate your payoff date without feeling any additional pain.  Good for you!  Your house will probably be paid off at least a couple of years before your friends and neighbors who bought at around the same time you did.  Here’s how to make this plan work.

Going back to our earlier example:  In January 2010, you bought a $500,000 house with a $400,000 mortgage, financed at 4.5% interest over 30 years.  As of January 1, 2016, your balance would be $357,241.03.  This is what your loan amortization schedule looks like:  (click to enlarge)

01.20 amortization

You refinance in January 2016 for another 30 year mortgage at 3.75%.  Your loan payment dropped from $2,026.74 to $1,654.44.  But instead of paying the lower payment amount, you continue making the same payments you were making before.  Now, instead of paying off your house by January 2040, you’ll be paying it off by June 2037.  Here’s what your new amortization schedule looks like:

01.20 amortization moderate 2

By refinancing and applying all of the money you saved on interest toward the principal payments on the loan, you shortened your loan term by 2.5 years.  The amount of time and interest you shave off your loan will depend on the individual circumstances, but you can calculate that easily by plugging the numbers into your own amortization schedule.

Create your own amortization schedule here, or if you don’t like following instructions, then simply download a template from Microsoft online or any one of the various websites that have them online.

The Aggressive Approach

This method should only be used by people whose goal is to pay off their mortgage as quickly as reasonably possible.  It might be possible to go more aggressive than this, depending on your financial situation, but for most people, this will be the most aggressive approach they can take.

This approach is based on the maximum debt to income (DTI) ratios allowed by most banks.  When a bank is determining whether to approve someone for a mortgage, it starts by examining the total amount of monthly housing costs (principal, interest, property taxes, and insurance) as a percentage of the borrower’s gross income.  This is called the front end ratio, and most banks cap it somewhere around 30–33%.  So if you earn $10,000 per month in salary before taxes, your housing costs can total between $3,000 and $3,333 per month before hitting the bank’s limit.

Next, the bank looks at the borrower’s overall monthly debt obligations as a percentage of the borrower’s gross income.  This is called the back end ratio, and most banks cap it somewhere around 43–45%.  If you earn $10,000 per month in salary before taxes, but you have a car payment and student loan payments that total $2,000 per month, the maximum the bank will let you borrow for housing would be the equivalent of $2,300 to $2,500 per month.

When you first get your mortgage, the bank will ensure that you’re under their DTI thresholds, or you wouldn’t be approved for the loan.  So at that stage, you don’t need to worry about it.  But in this approach, you’re going to re-analyze your own DTI ratios every so often, and ramp up your housing payments accordingly.

Once again, let’s start with our example: In January 2010, you bought a $500,000 house with a $400,000 mortgage, financed at 4.5% interest over 30 years.  As of January 1, 2016, your balance would be $357,241.03.  This is what your loan amortization schedule looks like:  (click to enlarge)

01.20 amortization

Let’s say your income stays fairly stable for a handful of years, but in January 2016, you get a promotion at work which comes with a meaningful raise.  Now, instead of making $92,000 per year, you’re making $110,000 per year.  In addition, you’re also able to refinance your mortgage for another 30 year mortgage at 3.75%.  Your loan payment obligation will drop from $2,026.74 to $1,654.44.

But instead of paying the lower payment amount, or even paying the same amount you were paying before, you recalculate your DTI to see how much the bank thinks you can afford to pay.  Let’s say you have no other debt obligations other than your mortgage.  Your DTI can be as high as 33%.  At $110,000 per year, you can spend $36,300 on housing costs.  Let’s say your property insurance is $1,000 per year, and your property taxes are $5,000 per year.  That leaves $30,300, or $2,525 per month, for mortgage payments.

By plugging in $2,525 into your amortization schedule as your new loan payment, you can see that your loan will now be paid off by September 2031, almost 10 years early!  Here’s your new amortization schedule:  (click to enlarge)

01.20 amortization aggressive 2

Before you close on the refinance, check with the bank to see if you can get a better rate for a shorter loan term, and to see if your monthly payment cap works with one of those loans.  If you can refinance for a shorter term and save even more interest, then great!  For example, in the above scenario, with a payment cap of $2,525, you could refinance for a 15-year loan at 3.25% and save even more interest:

01.20 amortization aggressive 3

In this scenario, you would save $21,229 over the life of the loan by refinancing to the 15-year loan instead of the 30-year, even though you’re making the same $2,025 monthly payments!

But here’s one rather large caveat: if the new payment obligation for the shorter loan term really pushes your personal comfort limits, or if it would mean trimming back your retirement account contributions or other savings, then don’t downsize for the shorter loan term.  It’s more important that you stay on track for your other savings.  Another benefit to the longer loan term is flexibility.  If you are saving for an investment property and you need to accumulate a down payment, or if you have an investment property which has very little cash flow, and you need the flexibility of being able to make a smaller mortgage payment one month to cover an emergency expense, then the longer loan term is worth it.

Whether or not you refinance, run your DTI numbers periodically, at least every few years or so, or when you have a significant salary increase, to see if you can ramp up your mortgage payments.  That’s what I did when I refinanced my house in late 2014.  I ran my DTI and discovered that I could actually refi for a 10 year loan, and make extra payments on top of that.  At this rate, my house will be paid off in about 8 years from the time I refinanced.  That will be just about 15 years from the date I bought the house, and I will be 43 years old.  (Of course, other things may happen to shift those plans slightly.  We’re currently selling our apartment building and I’m shopping for a replacement investment property, so my home mortgage may have to take a backseat to that for a little while, but we’ll see.)

Which mortgage payoff approach are you using?  Do you think it’s better to pay your mortgage off sooner, or are you allocating your savings to other methods?