When you prepay your mortgage, it means that you make extra
payments on your mortgage principal. Prepaying can save you thousands of
dollars in interest, pay off your loan early and build equity faster.
There are several ways to
prepay a mortgage:
- Apply a lump
sum after an inheritance or other windfall.
- Make an
extra payment every year.
- Add extra
dollars to every payment.
- Some
combination of the above.
How much can prepaying a mortgage save?
The benefit of prepaying your mortgage isn’t just in reducing
the monthly interest expense a tiny bit at a time. It comes from paying down
your outstanding loan balance with additional principal payments, which slashes
the total interest you’ll owe over the life of the loan.
Bankrate’s mortgage
amortization schedule calculator can help you figure out the
impact of extra payments on your mortgage. Click “Show amortization schedule”
to reveal the section that lets you calculate the effect off additional
payments.
What are the drawbacks of prepaying my
mortgage?
There are potential downsides to prepaying. For starters, typing
up your cash in your home means you have less liquidity and wiggle room in your
budget. In other words, you’ll have less readily available cash to put toward
increasing your 401(k) contributions or paying down high-interest debt. These
financial goals could offer a higher return on your investment.
Another consideration is the opportunity cost of not having that
extra money invested elsewhere. Over the past four decades the stock market has
returned an average of 10 percent a year. For the broad bond markets, the
average annual gain has been close to 8 percent.
When asking yourself, “Can I prepay my mortgage?” look at your
entire financial picture. Here are some important questions to consider:
- Is
your monthly budget tight after meeting necessary expenses?
- Is
your income variable and/or unpredictable?
- How
long do I plan to stay in my home?
- Are
you saving enough for retirement?
- Do
you have an adequate emergency savings fund of three to six months of
household living expenses?
- Do
you have a lot of high-interest credit cards or loans?
Assessing your financial goals, income and budget can help you
decide whether it makes more sense to address other pressing financial concerns
before paying ahead on your mortgage.
Do it yourself
Let’s say you want to budget an extra amount each month to prepay
your principal. One tactic is to make one extra principal and interest payment
per year. You could simply make a double payment during the month of your
choosing or add one-twelfth of a principal and interest payment to each month’s
payment. A year later, you will have made 13 payments.
Make sure you earmark any additional principal payments to go
specifically toward your principal. Lenders typically have this option online
or have a process for earmarking checks for principal payments only. Ask your
lender for instructions. If you don’t specify that the extra payments should go
toward the loan principal, the extra money will go toward your next monthly
mortgage payment. And that won’t help you achieve your goal of prepaying your
mortgage.
Once you have built sufficient equity in your home, you should
ask your lender to remove private
mortgage insurance, or PMI. Paying down your loan principal at a
faster rate helps eliminate PMI payments more quickly, which also saves you
money in the long run.
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