Mortgage Q&A : “Which mortgage should I pay off first?”
Today we’re going to talk about strategy if you hold multiple mortgages and want to reduce your total interest expense.
It’s not uncommon to have multiple mortgages, such as a first and second mortgage tied to the same property.
Or perhaps a couple mortgages on separate properties, such as one on a primary home and another on a second home (or investment property).
Before we dig into the details, paying down the loan with the higher interest rate is generally advised.
Generally Best to Pay Off Highest Interest Rate First
- Like any type of loan or credit card you may have
- It’s typically beneficial to pay off the one with the highest interest rate first
- Such as a second mortgage (as 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’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 ahead of time).
These days you have to question whether borrowers actually want to pay off their mortgages early, as many are locked in at record low rates that are quite favorable to hold onto.
Anyway, let’s look at an example to illustrate the savings:
1st mortgage: $200,000 loan amount, 30-year fixed @4%
2nd mortgage: $50,000 loan amount, 30-year fixed @8%
Extra payment: $100 per month
Let’s assume you’ve got a first mortgage with an interest rate of 4%, and a second loan set at a rate of 8%.
If you were to pay an additional $100 a month on your first mortgage, you’d save $26,855.30 in mortgage 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 a mortgage interest rate double that of the first mortgage.
It Can Depend on Loan Size
- Sometimes you can save money by paying off a lower-rate mortgage
- If the interest rate isn’t much lower than the other mortgage
- And the loan balance happens to be a lot larger
- In this case it could accrue a substantially larger amount of interest
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: $100 per month
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 $100 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.
Simply put, you really need to do the math (using an early payoff calculator) to determine which home loan to pay down first. It’s not always as simple as picking whichever 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 mortgage faster.
Consider All the Details
- There are other factors to consider beyond interest rate and loan amount
- Such as if one loan is fixed and another is an ARM (and subject to future rate increases)
- Or if you have other high-interest debt that should 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’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.
[How to pay off the mortgage early.]
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.
Speaking of, you could consider which loans are tax deductible and which are not, and add that to the overall decision as well.
Read more: Pay off the mortgage or invest?
You said :
“…make the extra payment on the larger first mortgage… 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.
…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.
…It’s not always as simple as picking whichever interest rate is higher”
I believe that is inconsistent, and incorrect– because you are comparing the amount of interest saved after X years, to the amount of interest saved after Y years — and X and Y are not equal.
In your example, you’re saying that :
– paying extra on the first one would save $34,085.83 in interest OVER THE LIFE OF THE LOAN, which would be 30 minus 3.5 = 26.5 years.
That’s only about $1,286.26 saved per year.
– paying extra on the 2nd one would save $29,223.42 in interest OVER THE LIFE OF THE LOAN, which would be 30 minus about 13.5 = about 16.5 years.
That’s about $2,164.70 saved per year!
Good point – then you can consider opportunity cost and erosion of money over time, tenure in the home/mortgage. So it’s certainly not as straightforward as it appears.