Mortgage Payoff: Lump Sum or Monthly?

by Kevin on March 5, 2009

When we bought our home we didn’t have 20% to put down. We were unknowingly in the middle of a real estate bubble. Yet we wanted to be smart and buy a home that we could easily afford. Our goal was to be below a rough 30% payment-to-income threshold for the house payment. We were especially lucky that we did not have additional debt coming into buying a house, so this would be our sole debt.

Thus we put 5% down on the house and got a 15% second mortgage to cover the balance from 80% on up. We can easily afford the payments and have actually been paying about a month early — a great layer of protection if we need it.

Was it the wisest decision to not wait until we had 20% to put down? I’m not sure. Only time will tell. As I have said several times while writing on this blog every situation is different. We knew what we were getting to upfront — we will pay higher interest costs than we would normally. But we wanted the house, we could afford the house quite easily, so we pulled the trigger and bought it.

I wouldn’t outright recommend everyone only put 5% down on a home (and good luck doing that these days anyways). It works for us because we have significant savings and significant cash flow at the end of every month. This is money that can go toward our savings snowball and if we need it to, to paying off the house faster.

Yet, we have a second mortgage. And it has started to bother me lately especially with the economy in shambles. I thought perhaps we should try to knock it out as quickly as possible and then apply what was our second mortgage payment to our first mortgage in an attempt to pay off the house very quickly.

What is the Best Way to Pay Off a Mortgage

With a new goal of paying off the second mortgage as quickly as possible, I began to ponder the different ways you can pay it off.

I came up with two methods:

  • put every extra dollar left at the end of every month toward the loan — just like you would with any other debt
  • put every extra dollar left at the end of the month in a savings account, save up the balance of the mortgage, and pay it off in one lump sum

Mathematically speaking, the first method is definitely the best method. The additional principal you pay every month reduces your long term interest immediately. This saves you the most money as possible.

In the past I’ve said I don’t buy the whole “managing your money is 80% psychological” that Dave Ramsey promotes. And I still don’t. With credit cards I have focused on the benefit of paying off the highest interest cards first rather than the smallest balances (psychological “wins”) first.

In this instance I am going to disagree with the best method from a mathematical standpoint.

But that doesn’t mean I’m buying into the psychological viewpoint either.

Saving Up to Pay Our Mortgage Off in a Lump Sum

No, the reason we are going to switch strategies (again!) to saving up a lump sum is due to the economy. The money that we have left at the end of every month will be swept into a savings account category specifically to be used to pay off the 2nd mortgage. Over time the fund will build up and we can pay off the mortgage all at once.

As the fund builds up it can act as an additional emergency fund for us. Hopefully we won’t need to use it — but if we did, that extra money will be sitting there to help us out. If either my wife and I lost our job, I would much rather have money sitting in a bank account than increased equity in our home. Equity can’t pay the bills. Money in a savings account can.

The Lump Sum Tradeoff

With the lump sum method you are trading lower interest costs overall to a margin of safety. I think this cost is worth it during these scary economic times. At the end of the day you are paying off the mortgage a lot faster than your normally would.

In our instance, if we saved up the extra money that we are anticipating having every month for 68 months and then paid a lump sum our total interest costs would be $14,968.

If we paid that extra money every month instead, our interest costs would drop to $9,398.

That’s a difference of $5,570. That’s big money where I come from, but imagine having that money in equity and not in cash. That could be an even bigger problem if an emergency hit.

Of course we may adjust our strategy again in the future. Being flexible is key with your finances. We may switch to where we save up the money every year and put 1/2 of it toward the mortgage at the end of the year. We’ll see. For now, we are switching to the lump sum method.

Hey Homeowners: Are you paying off your mortgage faster than normal? How are you doing it? Leave a comment and get the discussion rolling.

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{ 35 comments… read them below or add one }

Richard McLaughlin March 5, 2009 at 9:40 am

I know 2 people that tried the savings idea, one wanted to have the savings available ‘just in case’ and he never needed it. The other didn’t give a reason for not paying off in advance.
When guy2′s wife decided to leave she pulled all that savings out of the joint accounts leaving him with no backup cash.
Yet another reason to pay back as you can.

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Drew March 5, 2009 at 9:42 am

I think it is clearly worth paying $5,570 to have extra financial security for the next 5 and half years (security = knowing you can pay your bills without selling the house). If the job market wasn’t so volatile right now then that may not be the case.

Like you said though, it is a good idea to see how things are after a year or two and see how comfortable you are. If you are comfortable with your economic situation then you can start paying the mortgage instead of the savings account. This would save you money on interest while maintaining that comfortable feeling with some money in the bank.

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Kevin March 5, 2009 at 9:51 am

@Richard: I’m not convinced by your argument. Just because one guy didn’t need the money doesn’t mean I won’t. It’s certainly possible. And I sure hope it works out that way. But these are different economic times. There is an increased risk we would need the money.

And my wife is amazing and we are solid in our relationship. No need to worry about that.

@Drew: That’s the idea. If the economy turns around in two years and we’re making more money than ever and our jobs are more secure than ever… then we’ll probably change. But for now some additional safety net can’t hurt.

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Kelly March 5, 2009 at 10:40 am

If you don’t already have an emergency fund I would use the savings approach.

Figure out what a nice EF would look like to you and then after that’s established throw everything else at the debt.

I would imagine for a dual income couple, it may be less than you think, it’s unlikely you would both lose your jobs and not be able to find ANY work, you know? (even if it’s not in your chosen field)

Also for me it would depend on the interest rate you are paying and how that effects your taxes. There are more numbers to run then just how much interest you save (since a portion of the interest will be tax deductible).

As you said you are having no trouble making ends meet, so that makes the decision a little easier in my eyes.

Kelly
PS We also put 5% down on our current home, it was the right move for us as well. :)

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nostrebor March 5, 2009 at 12:58 pm

That’s why Dave says to have a 6 month emergency fund once all your debts are paid except for the house. Then once you do, you can hit the mortgage hard. Your “lump sum” method is the same as his, except you plan to use you “emergency” fund to pay off the house when you’ve got enough. I think your plan sounds pretty good as long as you’ve still got some sort of emergency fund when all is said and done. I like your website by-the-way! Thanks!

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Ashley @ Wide Open Wallet March 5, 2009 at 1:30 pm

We do a little of both. We pay an extra $100 a month to the mortgage and then we also save up and pay a lump sum of $1,000 once a year.

This year we decided to hold on to our extra $1,000 just in case. I just don’t feel comfortable sending away that extra cash right now.

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Kate@LivingTheFrugalLife March 5, 2009 at 1:37 pm

We *were* paying off our mortgage early, until last month. We’re just over two years into a 30-year loan, but because of our early payments, the actual term remaining is less than 17 years.

I was most definitely in the pay-it-off camp, as opposed to the save-it-up-and-lump-sum-it camp. In fact, I argued to sell stock to just pay the whole thing off. I wasn’t convincing enough, I guess. However, we’re now in a situation where it’s likely my husband will be out of a job in 4 months. So, yes, last month I canceled the automatic extra principle payment we had set up. We’re now saving that extra payment, and crossing our fingers that we won’t need it just to pay the bare necessities.

I’m very glad however that we were aggressively paying down the mortgage. We still have a chunk of equity in the house, despite the fact that values have fallen in our area.

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Finance Nerd March 5, 2009 at 1:45 pm

I agree with you, the mathematically optimal answer is not necessarily the best answer.

I’m assuming your second is a HELOC, but if it’s not the point remains. If you pay down your HELOC, there is a decent chance the bank lowers your credit limit and you lose access to that money. If it’s not a HELOC, but instead a loan, you can never recover the principal you pay, short of refinancing which is not easy right now.

One risk to consider is the likelihood you will “raid” the savings account. Not you specifically, but people in general. If you have the temperament that you would take the money out and buy a new TV, paying on the house is definitely the better plan. But, if you can leave the money in savings, and not touch it, building up a lump sum may be smarter in this economy.

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Kevin March 5, 2009 at 9:02 pm

@Kelly: We do have an emergency fund of 3 months of living expenses. We would like it to be more, but we are slowly building that up. We plan to keep these fund separate from emergency fund savings, but it provides the type of benefits you get from a larger emergency fund. Thanks for the comments.

@nostrebor: In this economic environment, do you think that 6 months is enough of a buffer? What about 3, 9, 12, 18 months? Glad you are enjoying the blog! Hope to see you back soon!

@Ashley: That’s exactly how I would feel. Good luck paying it down over time!

@Kate: Excellent example of why we think we’re going to hold off for now. It sounds “bad” to say sure, we’ll pay an extra $5,000 for a little additional safety. But it makes sense in this situation, for us. As Drew said, if the economy picks back up and we don’t feel the need for that increase margin of safety then sure, we might change tactics.

@Finance Nerd: It’s a loan rather than a HELOC. So you are exactly right, it is impossible to get to the money without a cash-out refinance (which comes with closing costs).

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Diane March 5, 2009 at 11:25 pm

Interesting article. My boyfriend & I just had this discussion, as I’m changing my way of dealing with this for the time being.

Basically I’m on the pay extra on the principal now side, and that’s what I had been doing since I refinanced my house 3 years ago. I refinanced for 30 years, rather than 15, figuring I could pay extra on the principal and pay it off early, but would not be tied to a higher note in case of emergency. Since I’m a single parent with 1 income I needed that cushion.

I did consider opening a HELOC and not using it, but now I know that is not a sure thing either, since banks are reducing credit lines.

I now have a good emergency fund, but I’ve decided to put the extra money into savings rather than pay extra on the principal for now. I can pay on the principal later, and in these uncertain economic times I’m going for the safety!

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Golfing Girl March 6, 2009 at 10:27 am

We also did the 5/15/80 loan about 6 years ago. We agressively paid off that 15% 2nd mortgage, but that was a couple of years ago when times where better. I think we’d do 1/2 and 1/2 now to savings and the loan.

We refinanced this year and got a 15-year to save 90K in interest but since the downturn kind of wish we had that 30-year payment. Oh well, at least we set up a HELOC that we don’t pay for if we don’t touch that gives us a little breathing room.

We’re only going to put an extra $100 on the mortgage until our emergency fund is at $10K. After that, assuming we’re still gainfully employed we’ll hit it hard again.

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financialwizardess March 6, 2009 at 1:13 pm

We have stuck with the pay-it-off-as-we-go approach (for now). We have a HELOC that is in good standing (zero balance owed) for $50K. We owe approximately that amount on the house still (after only 6 years of accellerated payments!). We also have Roth balances and taxable investment balances of approx $25K as of yesterday (horrible losses so far, so I hope this is the bottom).

I figure our monthly expenses (bare minimum – both unemployed) are approx $4500, so we need about $25K in an EF. However we are considering the Roths and investment accounts as our EF cushion right now with the HELOC as a backup. I think we can do this because we have such good credit and so much equity that the HELOC is in no danger of being reduced (I’ve talked with the credit union that holds our HELOC and they assure me we’re in no danger of being reduced/frozen). It’s a gamble, but we’re in sight of the finish line (Feb 2011!) for paying off the house, and we want to cross that line!

Everyone’s situation is different though…

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Kevin March 7, 2009 at 1:01 am

@Diane: I would do exactly are you are doing. Good job on paying the thing down so quick, but especially as a single parent I would want additional savings.

@Golfing Girl: I just hope that HELOC stays open for you — banks have been slashing credit lines recently.

@financialwizardness: That’s a tough gamble. Do you take the risk? It pays off in the end if you make it the whole way, of course. Best of luck to you.

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Monevator March 7, 2009 at 3:39 am

I like how you’ve taken the psychological aspects into this calculation, in favouring the accumulation of a lump sum.

So many personal finance writers say “here are the numbers, therefore that makes sense”. But having a plan is no good if you don’t feel you can stick to it.

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Do You Dave Ramsey? March 8, 2009 at 8:48 am

Good discussion Kevin… I can make a case for either method and would default to your method in these times.

Question – if there were no recession, would you maintain this course or switch back to the ‘pay as you go’ approach? I believe that I would switch to the ‘pay as you go’.

The economy is a HUGE factor so it must be a factor but I am curious as to the degree if would impact your approach.

Thanks!
Dave

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Kevin March 14, 2009 at 4:33 pm

@Monevator: I’ll be honest, that’s what I normally do (math over psychology). But in tough times I can see how the psychology trumps the math at this point.

@Do You Dave Ramsey?: My choice isn’t made based on the whole economy. It’s more my personal economy. If I were in a booming business then I might change my tune.

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Do You Dave Ramsey? March 14, 2009 at 4:46 pm

@ Kevin… yes, that’s a better answer and it represents how I should have asked the question. The economy is an external factor and we should make our decisions based on our personal factors… sometimes there is overlap and sometimes there is not.

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dan April 24, 2009 at 12:35 pm

Kevin is right, that putting it in a savings account is a mathamatically poorer answer.

However, I prefer the modified lump sum payment. Rather than a savings account, why not a CD? Rather than a CD, why not a t-bond? Rather than a t-bond, why not a bond fund? Rather than a bond fund, why not a mutual fund?

My point is that investing will make that lump sum grown faster than sitting in a savings account. If you invest you should be able to make 7-9%. That makes the lump sum both the psychological answer, and the mathamatical answer.

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Kevin April 27, 2009 at 8:54 am

@Dan: You’ve got to weigh risk and reward. If I am saving up to pay off my house there is no way in hell I’m putting it into a stock fund. Imagine being really close to paying off your home and then the market cuts your mutual fund holdings down 40% versus gaining 1% in a savings account or 3-5% in T-Bills or bonds?

No thanks. Some things just don’t deserve the risk.

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dan April 27, 2009 at 12:13 pm

Well Kevin, if not stocks, how about bonds? Hopefully you won’t give the bank a windfall by keeping a pile of cash in a savings account earning a miserly 1%.

Each person will weigh the risks/rewards differently on choosing how best to invest that pile of cash for the lump sum payoff depending on age, amount of time till mortgage pay-off, etc.

I am probably more comfortable with stocks, at least until I get close to paying off the debt, then I might shift into bonds (kind of like the theory that as you get closer to retirement you should become more conservative with your investments).

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Nate September 1, 2009 at 10:39 am

My wife and I do the biweekly method of paying our house off earlier. I think that this method works out perfect because you are using extra money that you don’t consider budgeted income. You see our budget consists of both of our paychecks in a typical month. I get paid on the 15th and the last day of each month and she gets paid every other week. Now for me there are 4 months throughout the year where I get a 3 week paycheck. But for her there are 2 months out of the year where she gets an entire EXTRA paycheck. This is what makes this method so perfect. We don’t have that money budgeted for anything. So what happens is our mortgage company takes out half of our payment every 2 weeks and at the end of the year we end up making one extra payment because of these two extra paychecks in the year. So we decided to set up our biweekly to fall on every friday that she gets paid. I think that this method is very difficult to beat because it really doesn’t require sacrificing elsewhere in the budget to pay off the mortgage faster. And if I remember correctly this method will cut almost 10 years off the life of our loan!!

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Accounting Leads December 12, 2009 at 1:48 pm

Even if you have the cash, I don’t think this is a great time to pay off your mortgage in full for a few reasons. First, interest rates are at historical lows (4.5 to 5%) and with the tax deduction you get you should be able to get a better return with your money in the marketplace. Second, with the real estate market tanking I wouldn’t be putting a lot of money into my home as who knows how low the market will go.

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Nate December 14, 2009 at 10:01 am

Accounting Leads
My mortgage is actually not at those historic lows. A lot of mortgages are not. I am at 6.25 and don’t have enough equity to refinance but am not in bad enough shape where I can get this stimulus assistance. And since I was reading in my magazine this weekend that it is predicted that returns for the market will be at or under 6% for quite some time. Meaning that even with my tax deduction it isn’t that big of a difference where it is worth it for me. And the key word is that you SHOULD be able to get a better return. We all know how fantastic that has all gone from recent events. Sure both the real estate and stock markets plummeted, but you still have to have a place to live. Having money in the market that is dropping by 30-40% doesn’t do you any good if your house drops a lot as well and then you end up owing more on the house then it’s worth. Lastly, you said that you wouldn’t want to put a lot of money into your home since the markets will go lower. But to me that is saying you are willing to pay more for something than you really have to, right? why pay thousands in interest more on something that could go lower if it could be paid off and you don’t have to worry about it anymore? those are a few of the reasons I think paying it off is a great idea!

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Laura January 5, 2010 at 9:30 pm

we are in your situation, but we can live on one income. Therefore, we will pay off our $55k condo this month, after 24 months with a $2000 emergency fund. If we weren’t able to live off of one income, then I would probably do what you’re doing.

Also, you can try an experiment in that for the next 6 months, pretend the lowest earner lost his/her job by getting fired and therefore there are no unemployment benefits. What would you do budget-wise? Revamp your budget and live like that for 6 months only. And do it hardcore! A trial run is great!!! You realize what you will refuse to give up (eating out once every 2 weeks for us — although eating out became subway with buy-one-get-one-free coupons instead of Macaroni Grill) and what you don’t miss so much (cable for us since we hulu, etc.). Then you can better plan your emergency fund and have confidence when the job is lost since you will know some of the pitfalls in advance.

The extra bonus will be adding all the lower income paycheck you’re no longer spending to the mortgage/EF. And if the trial run wasn’t so bad, continue doing all or most of the cutting back until the 2nd mortgage is gone. Figure out how long it would take you to complete this goal and count down the months. For us knowing 24 months was all we would have to do was important. If it was an endless run or it “maybe” would be 36 months — Bleh. That wouldn’t have been motivating enough. Good luck!

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family finance February 3, 2010 at 9:32 am

I’m having to make this decision. I have about 12k to pay off in order to get to 80% principal on our mortgage. I currently have about 12k in savings. So a lump sum payout would mean I would have zero in savings.

I can pay an extra $1000 each month for 12 months and then have some sort of security for 12 months (just in case I lost my job). But that means I’m losing $100 each month paying PMI. Do you have any suggestions?

Thanks! – family finance

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Nate February 6, 2010 at 2:09 pm

Family Finance-
It all depends on your own personal situation in my opinion. If the $12,000 is all of your savings then there is no way I would say you should deplete it to save $100 a month. You gotta have some sort of an emergency fund in case something were to happen. Think about it this way. Say you do deplete all of your savings and then you lose your job or get hurt and can’t work anymore. You would then have to pay for everything on CC without your savings there to back you up. And if you are only out for 3 months but your monthly expenses are 4k then you would owe 12k on a CC where you could have used that savings to keep that whole 12k off of the CC. I would say you should definately be putting extra towards your mortgage but don’t deplete your savings to do so. That $100 a month to pmi isn’t all that bad when you realize how much it could cost you just to get rid of it by depleting all of your savings! So say it was on your CC at that rate. It would take you 79 months to pay it off paying the minimum (2% of the balance). You would pay about 19k over this time to pay it off meaning it cost you 7k to go this route. Just something to think about when it comes to security. That is my opinion though, others may think something different!!

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Finance February 8, 2010 at 3:59 am

One risk to consider is the likelihood you will “raid” the savings account. Not you specifically, but people in general. If you have the temperament that you would take the money out and buy a new TV, paying on the house is definitely the better plan. But, if you can leave the money in savings, and not touch it, building up a lump sum may be smarter in this economy.

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Real Estate IRA February 15, 2010 at 11:40 pm

I agree…many folks simply do not have the discipline to save the money and may end up “raiding” the funds. Most people just can’t save the money, no matter what their income is.

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gypsy April 18, 2010 at 9:47 pm

tough choice in these times for sure…

have a cushion (EF) first the experts are saying 8 months of current expenses…

my goal is to have my mtg gone in 6 years… ambitious goal did a refi, for the good rates – have been doubling up on mtg payments every month for the past year while saving approximately 1/4 of what i am paying to mtg…

i am watching interest rates on investment opportunities… but until i see something secured in the 3% plus range… I am continuing to sock it on the mtg…

when (notice the optimism) things perk up a bit i may re-evaluate… but for now this is working for me…

i am divorced and trying to do it all on my own…

my motto “obstacles are the things you see when you take your eyes off the goal”

and LOL i don’t have a flat screen tv – not till the mortgage is gone :-)

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Jenn May 7, 2010 at 2:44 pm

Our only debt is the mortgage. Normally, each week we skim off the “excess” and either make an extra morgage payment or add to our retirement savings accounts. My company is in bankruptcy protection and won’t be coming out. I should be fine until July 1st but that’s about it. I won’t get a severance package but I will get paid for any unused vacation. I’ve banked just over 4 weeks so that is going to be my DIY severance package. Until I locate my next job we are temporarily suspending the weekly extra payments to the mortgage or retirement accounts and just holding the accumulating funds in a high interest savings account. I don’t like letting it just “sit there” but until I get settled into a new job I don’t want to put is someplace where I can’t easily get it back. If we need it to get us through any gap between jobs we’ll have it, but if I find a new job quickly we’ll eventually send it off to the mortgage or retirment accounts as usual, just a little late.

If we had any credit card debt I might be putting it there, with the idea that I could always take a cash advance back if I really needed to, but as far as I’m concerned if it’s hard to get it back or I’ll pay a penalty to do it, then I won’t cash I might remotely need back.

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Austin TX CPA June 3, 2010 at 1:41 am

I think with rates as low as they are I would stick with monthly payments. Rates are just so low that you should use the extra cash flow to pay down other higher interest debt like credit cards.

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Shannon July 6, 2010 at 12:37 am

We were one of the ones who did an 80/20 and now they have closed out our HELOC due to the falling prices of the home market otherwise I would just pump money back into the mortgage from our HELOC to continue to pay down the mortgage payments more.

My question is should I pay down the HELOC (the 20%) or the Mortgage (80%) first. The heloc is adjustable (in the 2-4% range) and the mortgage is fixed at 6%. I am not sure as we can’t refinance until the Heloc is paid off (although we have a decent rate now of 6% but its tempting when it gets even lower).

We are putting a 6-8 month savings together right now and have no credit card debt but after the savings I want to knock out the mortgage or Heloc just wondering which one.

Oh and for those paying off mortgages early be aware of the prepayment penalties if you have one. It’s probably still best to pay it off early and suck up the penalties. We don’t have a penalty after the first 2 years I think so we’re clear now not that I would have paid off our house in that amount of time anyway.

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Jennifer July 18, 2010 at 6:45 am

I have a first and second as well with an 80/15 split. We are paying on the 2nd loan because this is a heloc. Although the rate is currently 2.99%, it will go up when the market rates go up. Generally a heloc is prime rate plus some percentage. And the maximum rate can go to 18% or 21%, depending on the state’s maximum interest rate. So paying off the adjustable rate while interest rates are low makes more sense to me than paying on the fixed rate loan.

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Mike July 31, 2011 at 6:38 pm

I just discovered this post. Any update?

I understand completely why someone would want to make a lump sum payment. There is value in security.
My approach is more similar to the first one.
Since I am young, have an EF, steady job and low expenses — it makes sense.
But as ‘life happens’ my strategy could change too.

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mocA January 11, 2013 at 10:47 am

When we bought our first house, we kept some money in our savings so that two of us could pay our mortgage and live with food/utility at least one year without any income. Now, we’re using both lump sum and pay-off strategies.

One income is directly deposited to our savings account. The other goes to our checking account. Money in our checking account is used weekly to pay off our credit card balances (we pay soon as we see any $$ appears online.), mortgage, and utilities. We authorized the bank to make our official mortgage payment to the even number when we set up the account: Our official mortgage was $1,034.98, now it’s $1,050.00. Then every week or month, we’ll transfer extra money either to our checking or escrow account, but usually to escrow to save interests.

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