The wrong people are paying off their mortgages

Almost one in every four homeowners is paying off their mortgage at a rate faster than they’re required to — but the people who would benefit the most from this strategy are the ones least likely doing it.

The surprising new data comes from the major lender Rocket Mortgage, which analyzed early payments on nearly 3 million of its loans in all 50 states over the past five years.

The company found that people with the ultralow mortgage rates that were offered in 2020 and 2021 are actually much more likely than those with today’s high interest rates to pay off their loans faster than required, a counterintuitive finding that runs against financial advice.

The average extra contribution is equivalent to one additional full monthly mortgage payment per year, Rocket said. On a 30-year loan, that rate of excess repayment could mean shortening the loan by more than five years.

The way a mortgage works is that each monthly payment is a mix of a repayment of some of the loan itself (the principal) and an interest payment. When borrowers make additional payments, those voluntary contributions go entirely toward paying down the principal, not interest. That ultimately reduces the total amount of interest that the borrower will ever have to pay, since the borrower stops accumulating interest on the portion of the principal that’s been repaid. Prepaying doesn’t just mean paying faster, but actually paying less. It can reduce total interest by tens of thousands of dollars.

But the calculation isn’t as simple as thinking that paying more interest is worse. Borrowers who decide to pay extra have to think about how they could have used that money instead.

Interest rates today are much higher than five years ago — not just for home loans, but for bank accounts and investments, too. A person who could hope for a 5% return on money they invest in the stock market, but chooses to put that money toward paying off their 3% mortgage instead, is losing out on 2% of the value.

Indeed, a low mortgage rate is one of the most valuable ways you could free up your money to make better investments. “Financially speaking, if I have a 2.5% mortgage, I would rather pay them as slowly and as long as I can,” said financial planner Christopher Price.

That’s not what Rocket Mortgage’s data shows people have actually been doing. Instead, the company found that more than 1 in 4 people who took out mortgages in 2020, when rates were very low, have consistently been making extra payments almost the entire life of their loans, as have nearly as many who started mortgages in 2021. For those who started their mortgages more recently, and thus have interest rates about twice as high, the excess repayment rates are lower, about 1 in 5 borrowers making extra payments.

Price offered several reasons people might make this financial mistake. Some simply believe that debt is bad; many people in particular have the idea that they should hold no debts when they retire. Even a low-rate mortgage, which Price would consider a good debt to hold, spooks them. “I have this kind of conversation all the time,” he said. “The answer is: Don’t do it, if you have a 2.5% interest rate.”

Other borrowers, he said, don’t have the financial savvy to know how to invest their money. “Those people say: Hey, I don’t know what to do with this money. I’ve been getting raises. Where do I put it?” Instead of opening investment accounts, they pay more toward their mortgages.

Washington Post financial columnist Michelle Singletary disagrees, though she knows hers is a controversial position.

Singletary received outraged emails from readers when she disclosed that she had paid off her 2.75% mortgage eight years early. She argued that she preferred the increased monthly cash flow without any mortgage payment, and that she was guaranteed to save money on mortgage interest she’ll never pay, compared to an unknown return in the stock market. She also simply preferred the feeling of owning the house free and clear: “I hate debt.”

The higher rate of extra payments in the Rocket Mortgage data among those with low interest rates doesn’t mean people with higher interest rates don’t want to pay off their loans faster, too. But people who bought homes recently simply have much larger monthly mortgage payments than those who bought five years ago. Not only is their interest rate twice as high, but home values skyrocketed in that same time period. Most of them simply don’t have the extra money to put any more toward their mortgages, even to get out of a bad rate faster.