When is Prepaying Your Mortgage a Good Decision?
Everyone is buying a house these days. For many, it’s their first home purchase, and they have a lot of questions. How much should I put down, or how much home can I afford? Buying a home is a big financial move, and we all want to make sure we’re making wise decisions with our money.
Once you’ve actually bought the house, one of the key questions is: should you prepay your mortgage? Well, it depends on your mortgage goals. Identifying those goals will be crucial in determining whether or not setting up a prepayment plan is right for you.
Prepaying your mortgage: pros and cons
Most homeowners know they can probably save some money in the long run by prepaying their mortgage, or any loan for that matter. But if this is your first experience with a mortgage, you may not know exactly what that looks like or how much extra money can make a difference. Let’s look at some reasons mortgage prepayment may or may not make sense for your personal financial situation.
Pros of prepaying your mortgage
We all have unique life and financial situations, but if you can find a prepayment plan that works for you, there are some great reasons to prepay your mortgage.
Pay off your home faster and save on interest
The simple fact is that any extra money you pay towards your principal each month can be a good thing. It reduces the amount of interest you’ll pay over the life of the loan, and you’ll pay off your home faster. If your mortgage goals include paying less interest and paying off your loan ASAP, you have excellent reasons to consider prepayment.
Prepayment will help you build equity faster
If you haven’t got that much equity in your home yet, prepayment may help you save money by allowing you to cancel your private mortgage insurance (PMI). You will need to carry private mortgage insurance until your home reaches 20% equity, so if prepayment can get you there sooner, you’ll save yourself a good chunk of change.
Peace of mind
Another great incentive people find in paying off their mortgages early is the peace of mind it provides. Knowing you’re on the hook for less interest and have to make payments for a shorter amount of time can be a great driver. Owning your home free and clear can relieve the burden of making monthly home payments and simplify your monthly budget, especially if you are nearing retirement age and planning a life on a fixed income.
Cons of prepaying your mortgage
With all the great reasons to prepay your mortgage, you may wonder why everyone doesn’t do it. There are a few reasons why prepaying your mortgage isn’t always the best option.
Your bank charges fees
With some mortgages, the bank will charge you penalties or fees if you pay off your mortgage early. Most loans are exempt from prepayment penalties under the Dodd-Frank Act, but there are exceptions to the rule. You should check with your lender to learn whether or not your bank charges any fees for prepaying your mortgage. If it turns out your mortgage is subject to prepayment penalties, they can only be assessed for the first three years, so if you’ve already passed that point, you won’t have to worry about any penalties.
You can’t afford it
If your mortgage payment already eats up a substantial portion of your paycheck, you may want to hold off on tapping into your cash reserves. You may be better off making occasional lump payments when extra cash comes your way, like through tax returns or inheritances. Since that income likely isn’t part of your monthly budget, you can get away with devoting some of it to paying off your loan sooner, with less interest.
Let’s look at some key things you should keep in mind when deciding whether or not you can afford the extra payments.
Is my emergency fund healthy?
Life happens, and when it does, it often means we encounter unforeseen expenses. A general rule of thumb is that you should hang onto enough cash to cover around 3-6 months of expenses. This amount will get you through most emergencies. Don’t let your mortgage goals get in the way of securing your safety net to help you weather surprise storms.
Are you carrying balances on high interest credit cards?
If you’re carrying balances on high rate credit cards, you’ll want to pay those down before you pay down the balance on your home. The interest rate on your mortgage is likely far lower than that of even your lowest rate credit card, so paying your credit card down first is a better move. Take inventory of all your interest rates, and pay off the balances with the highest rates first to save yourself the most money.
Does it jive with your mortgage goals?
Sometimes the state of the economy can have a tremendous effect on the choice you ultimately make with your mortgage payments. Depending on things like interest rates, inflation, and your personal mortgage goals, prepaying your mortgage may or may not make sense.
If one of your main mortgage goals is to build the biggest amount of wealth, it may be best to pay your loan on schedule. However, if your goal is to pay the least amount of interest and own your home in the shortest amount of time, you’d be better off prepaying your mortgage and refinancing whenever you can find a better rate. If your interest rate is already very low, you may come out ahead by investing more of your money elsewhere and keeping your mortgage payment lower.
How to prepay your mortgage
There are a number of ways people choose to prepay, and each can be a great option. The only real difference is how they work for your particular financial situation and how much interest you are trying to cut from the life of your loan. By understanding the different methods, you can identify the best mortgage payment strategy for you.
Make one extra payment each year
Many people choose to simply make one full extra payment each year. If you can’t afford ongoing overpayments but want to pay more to reach your mortgage goals, you may choose to make that extra payment when you get your tax return, your yearly bonus, or any other time of year when you find yourself with a little extra cash.
If you prefer keeping yourself to a predictable schedule, bi-weekly payments might be a good option for you. By paying half of your monthly premium every two weeks, you’ll always make your minimum monthly payment on time, but by structuring it out every two weeks over the 52 week year, you’ll end up making 26 half payments instead of 12 full payments. That extra yearly payment will make a big difference, and you probably won’t notice that additional payment.
Add a little extra to each payment
With most mortgages, any amount you overpay on your monthly premiums goes toward principal, which both lowers the amount you still owe on your home and will result in less interest paid over the life of the loan. Even paying an extra hundred dollars on your principal each month could save you thousands of dollars in interest and help you pay off your loan sooner. It’s less ambitious than making entire extra payments, but you’ll stress less over the smaller amount.
Refinance with a shorter term
While this isn’t technically a prepayment plan, it can help you pay off your home faster and deserves a spot on the list. If you can get a great interest rate, it may make sense for you to refinance your mortgage to one with a shorter term. Depending upon how much equity you have, it’s possible that your payments will go up, but you’ll also own your home free and clear much sooner than you would with a longer ter
If you can find a great rate with payments you can afford, refinancing could be a solid option. If you’re not in the market to refinance right now, learn how to calculate the effective rate by prepaying your mortgage, and you may still be able to save some money.
The bottom line
At the end of the day, weighing whether or not to prepay your mortgage is a personal choice. It’s not all about knowing how to pay a mortgage off early, but knowing whether or not it’s right for you. Don’t make a decision until you fully understand the pros and cons that come along with each option and have a set of well-defined mortgage goals.
If prepayment gives you peace of mind and allows you to better plan for retirement, it may be a great option. If you have quite a bit of life left on your loan, you may make more money in the long run by investing those extra funds elsewhere. If you’re still unsure which option is best for you, consider consulting with a professional that can help point you in the right direction and reach your mortgage goals sooner.