Editor’s note: This article was first published in August 2022. The example rates of 1.75% and 6% and the inflation expectations reflect mid-2022. The Spanish income tax deduction for mortgage payments was abolished for homes bought from 1 January 2013; only older mortgages keep it.
Because mortgages can raise a lot of questions when it comes to personal finance, this article comes in two parts. In this first part, we’ll answer with numbers a question some readers ask when they want to make extra payments to pay off their mortgage early: is it better to make one large extra principal payment each year, or smaller extra payments every month?
In the second part, we’ll look at the pros and cons of taking out a 15- or 20-year mortgage (a shorter term, if you can afford it) versus a longer-term mortgage (30 years). On that second question we’ll find some answers that are, in a way, somewhat counterintuitive.
But we should start by making clear whether it’s a good idea to make extra mortgage payments to pay it off early, because it won’t always be the best option.
Reasons not to pay off your mortgage early
Suppose you have a €200,000, 30-year mortgage at 1.75% interest. If we’re in a situation where we think inflation is inevitable as a result of monetary policy and other factors, paying off your mortgage early may not be the best idea, because money will lose value in the future, so the money you pay toward your mortgage will be worth less in real terms. Also, at least in Spain, there are certain tax advantages when filing your income tax return because you’re paying a mortgage; that is, you can claim a deduction.
Second, you shouldn’t make extra mortgage payments if you have other debts with higher interest. This is obvious, but some people prepay their mortgage, which has a fairly low interest rate, while still carrying credit card debt at a much higher rate. In that case, put that money toward paying down your credit card or other consumer loans.
If you don’t have an emergency fund, prepaying your mortgage isn’t ideal either: you shouldn’t part with money you might need if something unexpected comes up. There are plenty of reasons to have an emergency fund, and in fact it’s a sign that our finances are ready for the unexpected.
Finally, if you’re the kind of person who feels more at ease with a good amount of cash on hand to take advantage of a business opportunity, it may be better to let the mortgage’s comfortable payment schedule run its course. Here we’re talking about a purely psychological factor.
With that cleared up, let’s see whether small payments or one larger annual payment works out better when prepaying our mortgage.
The best way to pay off our mortgage faster
To answer this question, we’ll use the maths of a couple of hypothetical scenarios, and to make things easier to follow I’ll round the numbers. In this first scenario, let’s assume a €200,000, 30-year mortgage loan at 6% interest, and compare the two prepayment options.
With an extra payment of €1,200 a year, it would take us 297 months to pay off the mortgage loan. In other words, we’d pay off the mortgage in 24 years (almost 25).
On the other hand, if we pay an extra €100 every month on top of the mortgage payment, we’d finish the loan two months sooner, saving a little over €1,800 in extra interest along the way.
Still, to be honest, over a 24-year period there isn’t much difference between doing it in a single annual payment and doing it monthly, considering the huge amount of interest we’re going to pay. And that’s without mentioning the impact of inflation.
But would this strategy have less impact if the mortgage term were shorter?
Let’s see. Take the same example with the same amount and the same interest rate, but now change the mortgage term to 15 years, which also means the monthly payment will be higher.
As we can see, regardless of the mortgage term, the answer is the same, although the difference between the two methods is much less pronounced on the shorter-term loan. In this case, with a single annual payment of €1,688 I would pay off the mortgage in 160 months, while paying an extra €140 every month would pay it off in 159 months (one month earlier). But whichever method you choose, it’s clear that prepaying produces considerable interest savings and that there is very little difference between a 30-year and a 15-year mortgage.
Now that we’ve seen the best way to pay off a mortgage faster, let’s look at the reasons why it’s advisable to take out a 30-year mortgage even if you could pay it off in 15.
See also: Why a 30-year mortgage is better even if you can pay it off in 15 years
Featured image: Álvaro Ibáñez, CC BY 2.0, via Flickr.
