Monday mortgage Q&A for a slow news day: “Which mortgage should I pay off first?”
If you have multiple mortgages, such as a first and second mortgage tied to the same property, paying down the loan with the higher interest rate is generally advised.
For example, if you’ve got a first mortgage at a rate of 6%, and a second mortgage set at 12%, it’d probably be in your best interest to knock out that second mortgage sooner rather than later.
That means making extra mortgage payments on the second mortgage if you’ve got the money handy (assuming you actually wish to pay down your mortgage).
These days you have to question whether borrowers actually want to pay off the second mortgage, as many are underwater on the mortgage and may default intentionally.
Anyway, let’s look at an example to cite the savings:
1st mortgage: $200,000 loan amount, 30-year fixed @4%
2nd mortgage: $50,000 loan amount, 30-year fixed @8%
Extra payment monthly $100
Let’s assume you’ve got a first mortgage at 4%, and a second at 8%. If you were to pay an additional $100 a month on your first mortgage, you’d save $26,855.30 in interest over the full duration of the loan, and shave 4 years and 11 months off the loan term.
Conversely, if you decided to pay an extra $100 a month on the second mortgage, you’d save $44,134.28 in interest and shave more than 14 years off the term.
So clearly the move here would to be pay off that second mortgage first, seeing that it has an interest rate double that of the first mortgage.
Of course, there are instances when the opposite could be true. Let’s look at another example:
1st mortgage: $300,000 loan amount, 30-year fixed @4.5%
2nd mortgage: $50,000 loan amount, 30-year fixed @6%
Extra payment monthly $100
Here we raised the loan amount on the first mortgage to $300,000. We also raised the interest rate on the first mortgage slightly, and lowered it to 6% on the second.
As a result, it would actually be in your best interest (no pun intended) to make the extra payment on the larger first mortgage, even though the interest rate is lower than that of the second. You would save $34,085.83 in interest over the life of the loan, and shave about three and a half years off your loan.
If you chose to make the extra $100 payment on the second mortgage each month, you’d only save $29,223.42 in interest, though you would shave 13 years and 7 months off the term.
Because the first mortgage is so much larger, a lot more interest accrues, and because the interest rates are fairly similar, the first mortgage winds up being more costly if paid down on schedule.
Put simply, you really need to do the math (using an early payoff calculator) to determine which loan to pay down first. It’s not always as simple as which interest rate is higher.
Of course, interest rates on second mortgages tend to be a lot higher than first mortgages, so the answer is usually to pay down the second faster.
Additionally, many second mortgages may be ARMs, such as HELOCs, so there’s the risk the rate could rise over time. This would give you more incentive to pay it off, to avoid any payment shock or increased interest expense.
Of course, it may not always be wise to make larger payments than necessary on your mortgage(s).
If you’ve got credit card debt at 18% APR, you’ll probably want to pay that off before making extra payments on your mortgage(s), which carries a relatively low interest rate.
Some homeowners seem to want to pay down the mortgage as quickly as possible while racking up thousands in finance charges on their credit cards, despite the fact that mortgage interest is tax deductible and credit card interest is not.
Read more: Pay off the mortgage or invest?