Homeownership offers a multitude of fiscal benefits. Aside from the obvious, a place to live, you can build equity in the property and eventually live rent-free. But owning a home is also a significant investment that can last for decades.
Today, most mortgages have terms that extend up to 30 years or more. While this makes the monthly payments affordable, decades of interest payments can add up to a substantial sum.
A common question among homeowners is whether they should pay off their mortgage early. After all, paying less interest and building equity quicker is smart, right? It’s a tricky question to answer. Before you start throwing extra cash at your home loan, read on to determine if it’s the right move for you.
Items to Consider:
Your home serves two functions. First, it’s a place to live and build memories with your family. Second, it’s a fiscal tool that can significantly affect your overall financial well-being.
Deciding whether to prepay your mortgage weighs heavily on your future goals. Begin by asking yourself the following question: “How long will I live in this home?”
- Long-Term Living: Prepaying a mortgage really benefits those individuals who plan to live in their homes for an extended period. It reduces the amount of interest paid and shortens the loan term.
- Short-Term Living: If your current house is a starter home or you know you’ll relocate in the near future, paying extra on your mortgage probably won’t provide substantial savings. While you will reduce the interest on the loan, you might instead consider using those funds on other life goals, such as building an emergency fund, saving for retirement, or starting a family.
NOTE: Before making prepayments on your mortgage, verify with your lender that there are no prepayment penalties. Also, ensure any extra payments go to the “principal” portion of your loan.
Two Methods to Prepay Your Mortgage:
When it comes to paying off your mortgage early, there are two popular strategies, lump sum payoff and ongoing prepayments.
- Lump Sum Payoff: If you’re nearing retirement and only have a few years left on your mortgage, you might be able to afford to pay off the entire balance at once. This method is called a lump sum payoff. You might also consider this option if you recently inherited money (or picked the winning Powerball numbers.)
- Ongoing Prepayments: The most common method to prepay your mortgage involves regularly making additional payments to your mortgage. While you can make extra payments anytime (assuming there are no prepayment penalties), here are three popular tactics:
- Extra Monthly Payments: This tactic involves making one additional payment over the course of the year. Take your current monthly payment and divide it by 12. Add that amount to each monthly payment. Again, ensure the extra funds go to the “principal” portion of your loan.
Ex: Current Monthly Payment = $1,200|($1,200 / 12 = $100) New Payment = $1,300
- Extra Annual Payment: Many people find it easier to make an additional payment once a year. Usually, they will time this around tax season and use their refund check or at the end of the year (if receiving an annual work bonus). Make one extra full payment and designate the funds toward your mortgage’s “principal” balance.
- Bi-weekly Payments: Some find it challenging to keep up with calculating or remembering to make extra payments. Switching from monthly payments to bi-weekly payments might be the perfect solution.
With bi-weekly payments, you make half your mortgage payment every two weeks. Because there are 26 bi-weekly payments a year, you end up making one extra full payment per year.
Advantages of Prepaying Your Mortgage:
- You decrease how much interest you pay over the life of your loan.
- You build equity quicker, which can be used toward other goals or as a financial lifeline.
- You have more disposable income available once your mortgage is paid off. This is extremely beneficial if you’re retired and living on a fixed income.
- You lessen the amount of time needed to pay off your loan.
- You have peace of mind knowing your mortgage is repaid and you no longer have a large debt to manage.
Drawbacks of Prepaying Your Mortgage:
- The extra money you invest into your home becomes tied up until you sell the property or withdraw it through a home equity loan.
- If your money is tied up in your home, it’s more susceptible to the housing market and economic fluctuations. For example, if the value of your home declines, you might not be able to access as much money with a home equity loan.
- By investing in your home, you lose out on other opportunities, such as:
- Paying down higher interest debt like credit cards.
- Saving for your retirement and investing in tax-advantaged accounts.
- Putting money aside for your child’s future college expenses.
To better illustrate the effect of prepaying your mortgage, review the following example of ongoing prepayments.
Assume you just financed a new home. Here are the details of your mortgage:
- Loan Amount = $300,000
- Interest Rate = 3% APR Fixed
- Term = 30 Years (360 Payments)
- Monthly Payment:
- Principal & Interest = $1,264.81
- Escrow (Taxes & Insurance) = $500
(The escrow figure is used as an example only and will vary depending on where you live and your insurance coverage.)
Using the “Extra Monthly Payments” method described earlier, the additional amount to pay monthly would be: $1,264.81 + $500 = $1,764.81 à $1,764.81 / 12 = $147.07
If you paid an extra $147.07 with each monthly mortgage payment (going to the principal balance of your loan), you would:
- Shorten your mortgage term by 4 years and 8 months (or 56 monthly payments)
- Reduce the amount of interest you pay by $26,945.40!
We’re Here to Help!
Deciding whether to prepay your mortgage can be tricky. It often helps to sit down with a mortgage specialist and run various scenarios, especially if you’re well into your mortgage term. A financial advisor can also provide insight into whether it makes more sense to pay off your home loan early or invest in other opportunities.
If you’re interested in speaking with a mortgage specialist, we’re here to help. Please give us a call at 202-479-2270.