To Prepay or Not To Prepay Your Mortgage

You’ve just settled on your new home. It’s an exciting time and you’ve got a lot of great plans for family’s future in your wonderful new home. But you’ve also got a new debt-a rather large one- for a thirty year duration. Should you try to pay this loan off sooner by prepaying on it? If you decide to prepay, how much should you pay, how often should you prepay, and what are the mechanics to make sure your payment is properly credited?

As to whether or not to prepay, the answer is based on simple economics. If, for example, your mortgage carries an interest rate of six percent (6%), this means that any prepayment you make will earn six percent. (saving six percent on your mortgage is the same thing as earning six percent). If you have another investment that earns more than six percent, you would be better served by not prepaying your mortgage, but investing in the alternative investment.

If you decide that your best bet is to prepay your mortgage, you have several choices at your disposal. There is a program known as a “bi-weekly mortgage”. The bi-weekly mortgage works in the following manner: If your monthly mortgage payment is $2,000; over the course of a year you would pay a total of $24,000. Under the bi-weekly plan, instead of making one monthly payment of $2,000, you would make a payment of $1,000 every two weeks. At the end of the year you would have paid $26,000 on your loan ($1,000 x 26 payments). This is the equivalent of making one extra monthly payment of $2,000. The extra payment will go toward loan principal and will have the effect of paying the loan off sooner. You may also voluntarily elect to pay more than $1,000 every two weeks. The choice is up to you. The more you pay every two weeks, the sooner your loan will be paid off. Many lenders are not set up to receive bi-weekly payments from their borrowers. There are companies that will handle your bi-weekly payments for you and turn the funds over to your lender. This is done by directly debiting your bank account every two weeks. There is usually an additional charge every time the account is debited. You must make certain to have the funds available in your bank account at the time designated for the charge to your account. This can sometimes be difficult for families with a limited budget. There is also the bi-weekly cost for the service. In spite of these costs, a bi-weekly mortgage program can significantly reduce the term of your mortgage depending on the interest rate and the amount of the prepayment.

Another method to use for prepaying a mortgage is to voluntarily add extra money to your normal monthly payment. Any monies so designated can be shown right on your payment coupon in the box marked “extra principal”. This will go directly toward reducing your loan principal. For example, on a $250,000 thirty year mortgage at 6% interest, the monthly principal and interest payment is $1,499. Adding an additional $100 per month to the payment for a total of $1,599 would reduce the term from thirty years to twenty-five and a half years. This would generate a net savings of more than $50,000 over the life of the loan. An additional $200 per month would reduce the term to twenty-two years, three months for a net savings of $86,000 over the life of the loan. The benefits of utilizing this method are: (1) There is no additional cost to you to implement this plan and (2) You don’t have to prepay every month. The prepayments are voluntary and if you’re unable to make the additional payment in a particular month, there’s no penalty for not doing so, as long as you make the regular monthly payment.

There is one additional method to utilize for making prepayments. You can add a lump sum to your regular monthly payment any time you choose. For example, if you have received a tax refund or a lump sum bonus, that amount can be added to your regular monthly payment. Under this method you are not making regular additional payments every month. Even though these payments can be made on an irregular basis, they will also serve to reduce your loan term.

If you begin making prepayments and decide to sell your home or refinance your mortgage before its full term, you will also benefit from prepaying because your principal balance outstanding will still be less than it would have been by making only the regularly scheduled payments.

Regardless of which method you choose, prepaying your mortgage can be a fairly painless way to generate significant long term savings.