Finance Globe
U.S. financial and economic topics from several finance writers.
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Prepaying Your Mortgage- Is It a Good Idea?
Is it a good idea to prepay your mortgage?
Mortgage prepayment is a topic that financial experts often don't agree on. Many financial advisors say that you can get a better return on your money if you invested the extra cash, rather than use it to pay additional to principal. Some money gurus argue that it's better to pay off a mortgage for the security of a sure thing and a guaranteed return on your money.
Homeowners who've purchased or refinanced in the last decade probably have a mortgage rate somewhere in the range of 5% to 7% for a thirty-year fixed. This is a pretty low rate, historically; mortgage rates in the 1980's ranged from 8% to 15% for a thirty-year fixed. It would be a no-brainer to pay extra additional to a mortgage at those kinds of rates.
But the answer is not so clear-cut at today's low mortgage rates. And, the mortgage-interest tax deduction brings the actual interest cost even lower. For someone in the 25% tax bracket, a 6% mortgage actually costs 4.14%. And, it's really not very difficult to get better than that with even fairly conservative investments.
However, the decision whether to pre-pay your mortgage is often more than being just about the money; many homeowners want the security of owning their home free-and-clear. For some, the emotional satisfaction of knowing they will always have a home to live in - without having to make a mortgage payment - may be more important to them than their net worth.
Pros
Cons
Homeowners that typically benefit the most from prepaying their mortgage:
Before you prepay your mortgage
Maximize your retirement contributions.Take full advantage of employer-matched 401k contributions before prepaying your mortgage; it's free money. Also, maximize your retirement contributions to benefit the most from a tax-advantaged account, whether a traditional or Roth IRA. It would be great to pay your house off early and have no mortgage payment when you retire, but don't neglect your retirement savings. Having a paid-off house and no retirement savings in your later years may mean that you'd have to tap into home equity just to cover your living expenses. You'll need more than just a roof over your head in retirement; make sure you also have the cash you'll need.
Eliminate your other debts. Before you tackle your mortgage, pay off high-interest debts first, including credit cards, high-interest auto loans, and personal loans. Don't even concern yourself with paying down a 6% mortgage if you have debts that cost you 18% annually. Get on a fast-track to debt elimination if it's important for you to accelerate your mortgage.
Save an adequate emergency fund. Financial experts recommend that everyone save three to six month's worth of living expenses. Make this a priority before you tie your money up in your home. This way, you'll have the money to pay for surprise expenses, and you'll avoid the need to tap back into your home equity if something were to happen.
Keep in mind...
Your "earnings" by prepaying your mortgage will be less than the interest rate if you itemize deductions. This can be an important consideration for those in the higher tax brackets with large mortgage-interest deductions. It may be less of a concern for those who are in the lower tax brackets, those who have few years left on their mortgage and minimal mortgage-interest deductions, or for those who take the standard deduction.
Some mortgages have prepayment penalties.Of the mortgages that do have prepayment penalties, many will allow you to pay up to 20% extra each year, in the first five years without penalty; after that, prepayment penalties are eliminated. Federal law prohibits prepayment penalties on FHA and VA loans. Some state laws also prohibit prepayment penalties. Check your loan documents or talk to your loan advisor to find out if your mortgage has prepayment penalties.
Prepayment Strategies
Avoid signing up for your mortgage company's bi-weekly payment program. The benefit, they say, is that you accelerate your mortgage by paying one additional payment a year through paying every two weeks; 52 weeks a year, 26 half-payments equals 13 full payments. First of all, they charge a fee of several hundred dollars to set up the bi-weekly payment program. Plus, you'll have twice as many due dates to keep up with, leaving less room for error and more chances to be assessed late fees if you forget to send payment. Do this on your own, by dividing one principal and interest payment by 12, and send that amount with each monthly payment.
Pay additional without committing to a program. Paying extra, on your own, also gives you the right to reduce extra payments if you experience a financial hardship. The experts often recommend that you send two separate payments, one for your regular mortgage payment and one for your additional principal payment, to prevent the mortgage company from applying your extra payment to something else, like escrow. But I've always sent one payment, mostly out of laziness, and the additional principal amount has always been applied accurately. Most mortgage companies will know what to do with the additional payment, but give them a call to find out their policy. Or, just take the extra minute to write a separate check or send a separate online payment. Then check your balance online to ensure that payment has been applied correctly.
Pay by the due date to ensure your extra payment is applied to the current month. Many mortgage companies give you about two weeks to pay your mortgage payment before it's considered late; if it's due on the 1st, you probably have until the 14th to pay it before they charge a late fee. But if you have an FHA loan, you'll want to get that payment in by the 1st so they can apply the additional payment to principal right away, otherwise, the additional payment won't be applied to your balance or save you money interest charges until the next month. If you're going to send additional principal payments, you might as well maximize its benefit. Give your lender a call to find out when extra principal payments must be received to be applied to the current month.
An easy way to pay extra to your principal is to round your payment up to an even hundred-dollar amount. For example, a thirty-year, 6% fixed rate mortgage for $130,000 will have a principal and interest payment of $779.42. Over thirty years of interest charges, this home will have cost $280,585.77. You could easily round that payment up to $800 without much impact on your budget, but that extra $20 a month will shave two years off your mortgage and save $12,080 in interest charges. Rounding your payment up to $900 will have your mortgage paid off 8 1/2 years sooner, and save $49,443 in interest charges.
To find out what kind of difference your extra payments will make on your current mortgage, try Finance Globe's mortgage payment calculator at: http://www.financeglobe.com/Finance/Calculators/what-if-i-pay-more-calculator.php.
Sources:
erate.com
getrichslowly.org
money.cnn
thedollarstretcher.com
smartmoney.com
Mortgage prepayment is a topic that financial experts often don't agree on. Many financial advisors say that you can get a better return on your money if you invested the extra cash, rather than use it to pay additional to principal. Some money gurus argue that it's better to pay off a mortgage for the security of a sure thing and a guaranteed return on your money.
Homeowners who've purchased or refinanced in the last decade probably have a mortgage rate somewhere in the range of 5% to 7% for a thirty-year fixed. This is a pretty low rate, historically; mortgage rates in the 1980's ranged from 8% to 15% for a thirty-year fixed. It would be a no-brainer to pay extra additional to a mortgage at those kinds of rates.
But the answer is not so clear-cut at today's low mortgage rates. And, the mortgage-interest tax deduction brings the actual interest cost even lower. For someone in the 25% tax bracket, a 6% mortgage actually costs 4.14%. And, it's really not very difficult to get better than that with even fairly conservative investments.
However, the decision whether to pre-pay your mortgage is often more than being just about the money; many homeowners want the security of owning their home free-and-clear. For some, the emotional satisfaction of knowing they will always have a home to live in - without having to make a mortgage payment - may be more important to them than their net worth.
Pros
- Mortgage prepayment is a guaranteed return on your investment, especially rewarding during times of market uncertainty.
- Forced savings - if your choice is between putting extra to your mortgage and blowing it on something superficial, prepaying your mortgage can be the better choice.
- Eliminating a monthly mortgage payment may make it possible to retire sooner.
- Freedom from a large mortgage payment may mean you'll be able to do other, more fun things with your money.
Cons
- Mortgage rates are often lower than what many investments could earn, meaning you could miss out on higher gains by tying money up in your home.
- Money paid into mortgage is not easily accessible; it is more difficult and costly to take money back out if you need it.
Homeowners that typically benefit the most from prepaying their mortgage:
- may be averse to having debt of any kind.
- may be averse to taking investment risk and are unlikely to get a better return on their money.
- may be nearing retirement and will be able to live comfortably, with considerably less money, if their mortgage payment is eliminated.
- have a mortgage rate that is higher than the return on their current investments.
- plan to stay put for at least five years.
- or, if selling in less than five years, would like to walk away from the closing table with more cash from built-up equity.
Before you prepay your mortgage
Maximize your retirement contributions.Take full advantage of employer-matched 401k contributions before prepaying your mortgage; it's free money. Also, maximize your retirement contributions to benefit the most from a tax-advantaged account, whether a traditional or Roth IRA. It would be great to pay your house off early and have no mortgage payment when you retire, but don't neglect your retirement savings. Having a paid-off house and no retirement savings in your later years may mean that you'd have to tap into home equity just to cover your living expenses. You'll need more than just a roof over your head in retirement; make sure you also have the cash you'll need.
Eliminate your other debts. Before you tackle your mortgage, pay off high-interest debts first, including credit cards, high-interest auto loans, and personal loans. Don't even concern yourself with paying down a 6% mortgage if you have debts that cost you 18% annually. Get on a fast-track to debt elimination if it's important for you to accelerate your mortgage.
Save an adequate emergency fund. Financial experts recommend that everyone save three to six month's worth of living expenses. Make this a priority before you tie your money up in your home. This way, you'll have the money to pay for surprise expenses, and you'll avoid the need to tap back into your home equity if something were to happen.
Keep in mind...
Your "earnings" by prepaying your mortgage will be less than the interest rate if you itemize deductions. This can be an important consideration for those in the higher tax brackets with large mortgage-interest deductions. It may be less of a concern for those who are in the lower tax brackets, those who have few years left on their mortgage and minimal mortgage-interest deductions, or for those who take the standard deduction.
Some mortgages have prepayment penalties.Of the mortgages that do have prepayment penalties, many will allow you to pay up to 20% extra each year, in the first five years without penalty; after that, prepayment penalties are eliminated. Federal law prohibits prepayment penalties on FHA and VA loans. Some state laws also prohibit prepayment penalties. Check your loan documents or talk to your loan advisor to find out if your mortgage has prepayment penalties.
Prepayment Strategies
Avoid signing up for your mortgage company's bi-weekly payment program. The benefit, they say, is that you accelerate your mortgage by paying one additional payment a year through paying every two weeks; 52 weeks a year, 26 half-payments equals 13 full payments. First of all, they charge a fee of several hundred dollars to set up the bi-weekly payment program. Plus, you'll have twice as many due dates to keep up with, leaving less room for error and more chances to be assessed late fees if you forget to send payment. Do this on your own, by dividing one principal and interest payment by 12, and send that amount with each monthly payment.
Pay additional without committing to a program. Paying extra, on your own, also gives you the right to reduce extra payments if you experience a financial hardship. The experts often recommend that you send two separate payments, one for your regular mortgage payment and one for your additional principal payment, to prevent the mortgage company from applying your extra payment to something else, like escrow. But I've always sent one payment, mostly out of laziness, and the additional principal amount has always been applied accurately. Most mortgage companies will know what to do with the additional payment, but give them a call to find out their policy. Or, just take the extra minute to write a separate check or send a separate online payment. Then check your balance online to ensure that payment has been applied correctly.
Pay by the due date to ensure your extra payment is applied to the current month. Many mortgage companies give you about two weeks to pay your mortgage payment before it's considered late; if it's due on the 1st, you probably have until the 14th to pay it before they charge a late fee. But if you have an FHA loan, you'll want to get that payment in by the 1st so they can apply the additional payment to principal right away, otherwise, the additional payment won't be applied to your balance or save you money interest charges until the next month. If you're going to send additional principal payments, you might as well maximize its benefit. Give your lender a call to find out when extra principal payments must be received to be applied to the current month.
An easy way to pay extra to your principal is to round your payment up to an even hundred-dollar amount. For example, a thirty-year, 6% fixed rate mortgage for $130,000 will have a principal and interest payment of $779.42. Over thirty years of interest charges, this home will have cost $280,585.77. You could easily round that payment up to $800 without much impact on your budget, but that extra $20 a month will shave two years off your mortgage and save $12,080 in interest charges. Rounding your payment up to $900 will have your mortgage paid off 8 1/2 years sooner, and save $49,443 in interest charges.
To find out what kind of difference your extra payments will make on your current mortgage, try Finance Globe's mortgage payment calculator at: http://www.financeglobe.com/Finance/Calculators/what-if-i-pay-more-calculator.php.
Sources:
erate.com
getrichslowly.org
money.cnn
thedollarstretcher.com
smartmoney.com
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