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Which mortgage should I pay off first?

Mortgage Q&A: “Which mortgage should I pay first?”

Today we’ll talk about the strategy if you have multiple mortgages and want to reduce your total interest expenses.

It is not uncommon to have multiple mortgages, such as a first and second mortgage attached to the same property.

Or perhaps mortgages on separate properties, such as one on a main home and another on a second home (or investment property).

Before we get into the details, it’s generally advisable to repay the loan at a higher interest rate.

In general, it’s best to pay the highest interest rate first

  • Like any type of loan or credit card you may have
  • It’s usually a good idea to pay off the amount with the highest interest rate first
  • Such as a second mortgage (because they often feature very high mortgage rates)
  • But you should take your time and do the math to be sure

Let’s consider an example. If you have a first mortgage at 6%, and a second mortgage at 12%, it’s probably in your best interest to cancel the second mortgage sooner rather than later.

This means making additional mortgage payments on your second mortgage if you have the money on hand (assuming you actually want to pay off your mortgage early).

These days you have to wonder whether borrowers actually want to pay off their mortgages early, as many are locked into record low interest rates and are better off holding on.

Anyway, let’s look at an example to illustrate the savings:

First mortgage: Loan amount $200,000, 30-year fixed at 4%
Second Mortgage: Loan amount $50,000, 30-year fixed at 8%
Additional payment: $100 per month

Let’s say you take out a first mortgage with an interest rate of 4%, and a second mortgage with an interest rate of 8%.

If you were to pay an additional $100 per month on your first mortgage, you would save $26,855.30 in mortgage interest over the entire term of the loan, cutting 4 years and 11 months off the loan term.

Conversely, if you decided to pay an additional $100 per month on your second mortgage, you would save $44,134.28 in interest and cut more than 14 years off the term.

So obviously the step here is to pay off the second mortgage first, knowing that the interest rate on the mortgage is twice the rate of the first mortgage.

What about different loan amounts?

  • It may seem like you can save money by paying off a mortgage with a low interest rate
  • If the interest rate is not much lower than another mortgage
  • The loan balance happens to be much larger because it may accrue a much larger amount of interest
  • But you need to take into account the different repayment periods and use the money accordingly

Here’s an example when it seems the opposite might be true. Let’s look at another example:

First Mortgage: Loan amount $300,000, 30-year fixed at 4.5%
Second Mortgage: Loan amount $50,000, 30-year fixed at 6%
Additional payment: $100 per month

Imagine we increased the loan amount on our first mortgage to $300,000. We also raised the interest rate on the first mortgage slightly, and lowered it to 6% on the second mortgage.

As a result, it appears to be in your best interest (no pun intended) to make an extra payment of $100 on your larger first mortgage, even though the interest rate is lower than your second mortgage.

You’ll save $34,087 in interest over the life of the loan, cutting about three and a half years off your loan.

If you choose to make an additional $100 payment on your second mortgage each month, you’ll save only $29,226 in interest, even though you’ll save 13 years and 7 months of term.

Because the first mortgage is much larger, more interest accrues, and because the interest rates are fairly similar, the first mortgage becomes more expensive if it is paid off on time.

We have to take into account the savings resulting from early repayment that can be applied to the remaining loan

But it’s not that simple. If we applied the extra $100 each month to the second mortgage, it would be paid off in 16 years and five months.

Technically, this means there is now an extra $300 available ($299.78 being the old monthly payment on the second mortgage) to put toward the remaining first mortgage balance.

Remember, your first mortgage will require an additional $100 over approximately 26 years and five months to realize the full interest savings.

With the second mortgage payment of about $300 made about ten years ago, it can now be applied to the first mortgage for the remaining term of the loan.

So you can apply an additional $300 per month to your first mortgage starting around month 198.

Arguably, if you could deploy $400, you would have $300 freed up and the $100 you were previously paying additional.

If you put an additional $400 toward your first mortgage starting in month 198, you will save $17,581 in interest on your first mortgage.

The loan will still be paid off approximately three and a half years earlier, just as if you had paid $100 into it instead of the second mortgage.

Collectively, your interest savings would be $46,807, taking into account the $29,226 saved on the second mortgage.

That would be much better than the $34,087 in interest saved just by applying $100 to the first mortgage from day one.

In short, make sure you do the math (using our early return calculator) to determine which home loan to pay off first.

Of course, interest rates on second mortgages tend to be much higher than first mortgages, so the answer is usually to pay off the second mortgage faster.

Just be sure to transfer the monthly savings to the remaining loan once the other loan is paid off.

Consider all the details beyond interest savings

  • There are other factors to consider other than the interest rate and loan amount
  • For example, if one loan is fixed and the other is an ARM (and subject to future rate increases)
  • Or if you have other high-interest debts that need to be paid off first
  • Such as a high-interest credit card, student loan, or personal loan

Additionally, many second mortgages may be ARMs, such as HELOCs, so there is a risk that the rate could rise over time.

This would give you more incentive to pay it back, to avoid any payment shock or increased interest expenses.

[How to pay off the mortgage early.]

Of course, it may not always be wise to make larger payments than necessary on your mortgage.

If your credit card debt has an 18% APR, you’ll likely want to pay that off before making additional payments on your mortgage, which carries a relatively low interest rate.

Some homeowners seem to want to pay off their mortgage as quickly as possible while piling up thousands in finance charges on their credit cards, despite the fact that mortgage interest is tax deductible and interest on credit cards is not.

Speaking of which, you can think about which loans are tax deductible and which are not, and add that to the overall decision as well.

Read more: Paying off the mortgage or investing?


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