Why Banks Hate When You Pay Off Your Mortgage Early
Banks are legal entities that operate with a unilateral financial objective to generate profits – the more, the better!
It is just that simple.
The interest income generated from a portfolio of mortgage loans tends to be one of the bank’s most significant revenue sources. However, the exact proportion of revenue depends on the lender’s diversification.
But any way you slice it, lenders never appreciate it when a mortgage contract is paid in full early.
When a mortgagor/borrower chooses to pay their mortgage in full – before the mortgage instrument’s last scheduled payment, the bank’s fiscal strategists must now revise its anticipated income expectations downward, even if only temporarily. This unexpected cash flow reduction slashes revenue that eventually disrupts funding for budgetary items – like the offering of additional customer services, or the ability to fund new future-planned projects, etc.
And, to make matters even more challenging, bank executives are now tasked with the responsibility of locating another safe, well-performing, collateralized financial investment that pays returns that are similar to the mortgage that was just paid off.
However, this task is not always simple to complete because the market and interest fluctuations occur daily, monthly, and yearly, etc.
If a mortgage-paying 7% is paid in full when the current interest rate environment averages 4.5%, it is likely that a bank/lender will find it nearly impossible to replace a 7% collateralized loan in that reduced rate environment. So, even if the bank re-lends the money at market rates, they will still have lost a return of 2.5% (7% – 4.5% = 2.5%) per year – which would be $5,000 for a $200,000 mortgage loan. [$200,000 * 2.5% = $5,000]
Banks become particularly grouchy when a mortgage is paid in full within the first few years from the date of origination because the processing expenses of the loan (incurred by the bank at the time of origination, etc.) likely exceed the interest income generated by the mortgage during the investment’s first few years.
In other words, most lenders need some time to hit their investment breakeven point; if the mortgage is paid before that breakeven moment, the lender faces investment losses, in addition to a future income stream.
So, given the information noted-above, a lender always prefers an active, well-performing mortgage because this lending scenario –
- Maintains a predictable, dependable income flow that helps a bank meets its financial obligations and plans.
- Offers a collateralized investment opportunity for added investment safety.
Ironically, banks have no control as to whether a mortgage is paid off early – unless there is a prepayment penalty clause included in the mortgage/legal paperwork. However, in the current mortgage marketplace, a prepayment penalty is a relatively rare occurrence.
The Bottom Line
Lenders do not like it when borrowers pay off their mortgages early because a satisfied mortgage muddles its budgets and future projections. Banks are number-crunching experts, and they never appreciate anyone messing with their income figures.
A mortgage that is terminated ahead of its due date creates additional work for bank staff members, as they are now tasked with the responsibility of replacing the investment with similar terms and safety.
Lenders prefer to maintain control of their assets and investments. The fact that borrowers can independently decide to pay off a mortgage without its input unnerves any lending institution.
However, how a lender reacts to a mortgage loan being paid in full early belongs exclusively to the bank.
Borrowers, on the other hand, must gather enough information to make an educated decision as to whether it is a prudent idea to pay down (or off) a mortgage.
Is it a Good Idea to Pay Off a Mortgage Early?
So, is it a Good Idea to Pay Off a Mortgage Early?
The short answer is, it depends. It depends on many things. It depends on each borrower’s mortgage terms & financial situation. But remember, the primary premise behind this economic reasoning is to discover the ways in which an individual can either reduce expenses, increase income, or a bit of both.
The fundamental financial question for a borrower with an outstanding mortgage would be –
- If you have enough money to pay off your mortgage today, would it be smart to pay off the mortgage? OR,
- Would it be a more intelligent financial decision to use those same funds to generate income through other investment(s)?
More information is needed to answer these questions with any semblance of precision.
To further complicate matters, though, borrowers must also consider if it would be a good idea to simply pay down their mortgage gradually, rather than pay it off in full. There are many ways to begin to pay down a mortgage balance . If this is the strategy one chooses, the earlier one begins paying down their balance, the better because you are strategizing with time, rather than against it.
Begin by gathering data relevant to your entire financial situation, plus the terms of your mortgage loan.
What is your current mortgage interest rate?
- Is a better interest rate available in today’s marketplace?
- Is it a fixed or an adjustable rate?
What is your total PITI (Principal, Interest, Taxes & Insurance) payment each month?
- Is there a way to reduce one’s real estate taxes (through abatements, etc.), homeowner’s insurance, or PMI payments?
How many years are left on the term of your current mortgage?
- Is it worthwhile to spend the money required to close on a mortgage to lower the interest rate when the mortgage loan is nearing its expected termination date?
- Is it worthwhile to extend the mortgage due date (by refinancing) to lower your payments?
What is the current balance of your outstanding mortgage balance?
- Has the balance increased due to negative amortization?
Is there another investment opportunity (or two) for your available funds?
- If the money one would use to pay down (or payoff) a mortgage balance offers better returns on another investment (other than the interest you are paying on your mortgage now), would it still be a good idea to pay off the outstanding mortgage balance?
Is there a way to eliminate the monthly Private Mortgage Insurance (PMI) payment?
- Private Mortgage Insurance (PMI) is required if a borrower’s down payment is less than 20% of the subject property’s purchase price. Reducing a mortgage balance (which is then compared to the current appraisedmarket value of the homecollateral when you choose to pay down your mortgage) is a wise decision, because, if a borrower can meet the threshold where Private Mortgage Insurance is no longer warranted, the PMI monthly payment drops automatically.
Does your paying off your mortgage in full offer peace of mind – a valuable attribute for any homeowner?
- Sometimes, though, it is more about one’s peace of mind than a bottom-line fiscal goal. For certain homeowners who owe on a mortgage is simply stress-inducing. For those nearing the retirement finish line, a house that is free and clear frees up disposable income while enjoying retirement.
Mortgage Interest Offers Tax Deductibility
An analysis regarding the value of paying off a mortgage early must also include an essential discussion regarding the positive income tax ramifications offered by the Internal Revenue Service’s (IRS) guidelines.
The Internal Revenue Service offers a tax write-off to homeowners with mortgages as a way to encourage and support homeownership.
- The mortgage interest you pay will likely meet the Internal Revenue Service’s IRS definition of an income tax deduction. The tax-deductible status of mortgage interest is one of the few income tax write-offs remaining with regards to IRS interest deductions.
- Note – The IRS rules regarding the tax-deductibility of a borrower’s primary residence and a second home have been modified in the not too distant past. The tax overhaul that was effective in 2018 nearly doubled the standardized deduction – which is now $24,000 . This increase was designed as an incentive for homeowners to apply the standard deduction to their tax returns, and NOT itemize their tax-deductible line items.
- Borrowers are encouraged to speak to a tax attorney to determine the financial impact a mortgage interest-deduction would have with regard to one’s federal government income tax liability. This information is a final determinant as to whether it is a good idea to pay off your mortgage early.
- When accounting for a tax-write-off of mortgage interest, the revised interest rate (the effectiveinterest rate being paid when accounting for tax deductions) will most likely decrease, because the write-off is an advantage to a borrower.
How to Know if it is a Good Idea to Pay a Mortgage Early
It is crucial to identify one’s prioritized financial objectives, as they will help develop the most well-informed decision one can make regarding the payoff of your mortgage.
What is your number one priority regarding the existing outstanding mortgage?
- Is it to reduce the monthly mortgage PITI (Principal, Interest, Taxes, & Insurance) payment? The four PITI components can each be reduced independently of one another.
- Is it to reduce the interest rate, which will likely reduce the monthly payment?
- Is it to reduce the remaining mortgage term (which can save tens of thousands of dollars over the life of the mortgage?
- Is there another investment that would likely offer returns in excess of the mortgage interest you pay on an annual basis?
- Is it to extend the term of the mortgage loan to lower your monthly mortgage payment?
Consider this example:
John has an outstanding mortgage balance of $100,000, with a 4% interest rate, and 23 years left on the mortgage note. His mortgage interest tax write-off from the IRS reduces the effective interest rate of the mortgage to 3.75%.
John has been offered an investment opportunity that requires a $100K investment with returns equal to 4.5%.
The following is John’s dilemma:
John recently inherited enough money to either pay off his mortgage or to jump into the investment opportunity recently presented to him.
Does it make sense for John to keep his current mortgage as is if the inheritance monies have the opportunity to pay an annualized yield that exceeds the mortgage interest rate?
To help provide some context, consider that since the inception of the S&P 500 (in 1926), the average annual return for this investment hovers around 10%. Financial gurus tend to consider S&P’s nearly 100-year average performance as a reasonable standard when making long-term financial investments.
Now for John, an 8% return on the investment might suffice; however, another borrower might need a 9 or 10% return to choose to invest, rather than pay off their mortgage balance. However, borrowers should be aware that no matter how careful and studious one can be in these financial decisions, there is an inherent risk which must not be overlooked –
- Are the investment’s returns guaranteed?
- How long will it take for the investment to pay off?
- Can the investment be liquidated with relative ease, if money is needed expeditiously?
- Are there potential for monetary losses?
- Is there a better investment for John to consider?
- Will the investment decrease one’s emergency funds to an unacceptable level, by leaving the borrower cash poor?
The reality is, the risk is always present as it is created by the uncertainty of investments, and life itself. The trick is to make a well-informed, educated financial decision that acknowledges and calculates the risk in the final decision.
The Good and Bad News of Paying Off Your Mortgage Early
The Pros for Paying A Mortgage Off Early
There are many smart reasons to pay off a mortgage early –
- It eliminates a monthly outlay and frees up disposable income. This is especially helpful for those on fixed incomes, like retirees and the elderly.
- It eliminates an interest payment, which could translate to a savings of thousands of dollars.
- It eliminates the worry and anxiety associated with carrying large amounts of debt. It also so sets up a way to live with a peace of mind that only happens when one is debt-free.
- It sets up an opportunity to grab some equity from your home in the future if needed.
The Cons for Paying A Mortgage Early
Here are a few reasons NOT to pay a mortgage early –
- Much of one’s financial liquidity becomes locked up in real estate. While available, access to home equity requires a series of paperwork and a few weeks, at the very minimum.
- A borrower will lose their mortgage interest tac write-off, i.e., tax liabilities increase.
- It can be challenging to sell your home quickly should there be a job loss or an emergency when you might money pronto.
- One might miss another investment opportunity with equity tied up in real estate.
Options to Pay Down a Mortgage Ahead of its Completion Date
Before one should consider paying down/off a mortgage, it is crucial to make sure there is an emergency fund set up in preparation for unexpected expenses and costs. This smart fiscal policy applies to the non-liquid funds in a mortgage and retirement funds as well. Most financial advisors suggest having a minimum of six months of expenses saved, before one even considers paying a mortgage down or in full.
Suggestions for Paying Down a Mortgage Ahead of Schedule
At this point, if it makes sense to pay down your mortgage, without paying it off as a lump sum, consider these mortgage payoff tactics.
Consider the bi-weekly mortgage plan
Essentially, a bi-weekly mortgage plan sets a borrower on track to pay an amount equal to payments 13 months of mortgage payments each year, instead of 12 payments. This concept is easily explained–
There are 52 weeks per year, which would translate to 26 bi-weekly payments. Twenty-six payments made every two weeks is equivalent to 13 monthly payments. While some lenders promote this service (some even charge a fee), a borrower can choose to do it at any time for their mortgage.
Bi-weekly payments are a smart way to pay down your mortgage while keeping portions of your income to work towards another financial goal, or two.
Consider a refinance of the current mortgage to either lower the rate or to reduce the term of the mortgage loan.
It works this way:
- If a mortgage is refinanced to reduce the rate – with all other terms remaining the same – the monthly mortgage payment will be reduced. However, most mortgage refinances require closing costs to secure. The total of the closing costs will lower a borrower’s savings.
- It a mortgage is refinanced to reduce the term of the mortgage – with all other terms remaining the same – the monthly payment will likely increase. The amount of increase is contingent upon just how much a borrower chose to shorten the mortgage term. For example, a mortgage reduced from 23 years to 15 years will increase the monthly mortgage payment a bit less than a mortgage term being reduced from 28 years. Either way, though, reducing the duration of a mortgage is a great way to save thousands of dollars of interest payments, if one can afford it.
- Eliminate the need for Private Mortgage Insurance (PMI). PMI is an insurance policy borrower pay each month because they bought a home with a down payment that is less than 20% of the purchase price, although some lenders self-insure and raise the interest rate instead of requiring PMI from a third-party source.
Lenders have pre-set thresholds when PMI insurance is no longer because the borrower has reached a sufficient equity position in their home. This threshold may differ from lender to lender, but the good news, the decision to eliminate PMI is based off a current appraisal – so if your property value has appreciated since the mortgage was originated, that can be quite helpful.
Here are a few insightful financial suggestions regarding other ways to better manage all of your financial debt. Ultimately, a well-managed personal financial world helps free up funds to help pay down/off your current mortgage.
- Be sure that you are preparing for retirement by making maximum investments in IRS allowed interest-deferred retirement investments like an IRA, 401(k) or a pension fund, if applicable. Investments growing as tax-deferred investments are the kinds of investments that provide tremendous returns over time.
- Be sure that you are focusing on paying off high-interest debt before paying down a mortgage, which has a lower rate and tax write-off possibilities. Types of high debt include:
- Credit Cards
- Auto Loans
- Higher interest rates for second mortgages or equity lines of credit
- Personal Loans
- Payday Loans
Through many generations of homeowners, the act of homeownership has performed admirably as the country’s most-used piggy-bank. Some view homeownership (and mortgage payments) as a forced savings technique. Each borrower gets to decide how to manage their financial obligations.
The decision to eliminate or pay down a mortgage is first and foremost, a personal decision.
It’s essential to determine how your financial scenario fares when considering the important and relevant factors influencing one’s decision to pay off, or pay down, their mortgage loan.
Like most things in life, each individual’s financial situation is unique. As a result, each borrower must decide (with some research and/or advice from a trusted advisor) if reducing or paying off a mortgage is a sound, practical financial decision.