Prepaying Your Mortgage Prepayment: How Reducing Your Loan Principal Can Save Big Money
When you prepay your mortgage, it means you are making additional payments on your principal loan balance. Paying off the extra principal on your mortgage can save you thousands of dollars in interest and help you build equity faster.
There are several ways to prepay a mortgage:
• Make an additional mortgage payment each year
• Add extra dollars to every payment
• Apply a lump sum after an inheritance or other windfall
• A combination of the above
The benefit of paying extra principal on a mortgage isn’t just that you reduce monthly interest charges a little bit at a time. This is the repayment of your outstanding loan balance with additional mortgage principal payments, which significantly reduces the total interest you will have to pay over the life of the loan.
Prepayment has potential drawbacks. For starters, tying your money in your home means you have less cash and less wiggle room in your budget. In other words, you will have less money available to increase your 401 (k) contributions or pay off high interest debt, for example. These financial goals could offer a better return on 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% per year. For bond markets in the broad sense, the average annual gain was close to 8%.
When you ask yourself, “Can I prepay my mortgage? »Take a look at your entire financial situation. Here are some important questions to consider, including:
Is your monthly budget tight after covering the necessary expenses? Is your income variable and / or unpredictable? How long do you plan to stay at home? Are you saving enough for retirement? Do you have an emergency savings fund sufficient for three to six months of household living expenses? Do you have a lot of credit cards or high interest loans?
Evaluating your financial goals, income, and budget can help you decide whether it makes more sense to deal with other pressing financial issues before you pay off your mortgage.
Prepaying your mortgage early is a great goal to achieve, but before you do, make sure you’ve hit these financial milestones first:
• Get the match. If you don’t get the full business value of a workplace pension plan, you are missing out on instant return. The typical business match is 50-100% of your contribution – up to a limit (often up to 3-6% of your income).
• Pay off your debt at a higher rate. It doesn’t make sense to pay off a 4% mortgage if you have 16% or higher credit cards.
• Plan for emergencies. A savings account with at least three to six months of spending can help you get over most setbacks.
• Protect yourself. You need to be adequately insured, which for most people means having home, health and disability insurance policies. If you have financial dependents, you will probably want life insurance as well.
Once those basics are covered, prepaying a mortgage comes down to discipline and comfort level. Do you want to completely free yourself from your debts? Or would you prefer your money to work harder for you in some other way?
Ideally, you want to pay off your mortgage before retirement so you don’t have to worry about those monthly payments if your income becomes more constrained.
Suppose you want to budget an additional amount each month to prepay your principal. One tactic is to make an additional mortgage principal and interest payment per year. You can simply make a double payment in any month of your choice or add a twelfth of a principal and interest payment to each monthly payment. A year later, you will have made 13 payments.
Be sure to direct any additional principal payments towards the principal of your mortgage. Lenders usually have this option online or have a check allocation process for principal payments only. Ask your lender for instructions.
If you don’t make it clear that the extra payments are to go to the mortgage principal, the extra money will go towards your next monthly mortgage payment, which will not help you meet your mortgage prepayment goal.
Once you’ve built up enough equity in your home (at least 20%), ask your lender to remove private mortgage insurance, or PMI. Paying off your mortgage principal at a faster rate eliminates PMI payments faster, which also saves you money in the long run.