How reducing your loan principal can lead to big savings
When you prepay your mortgage, you are making additional payments on your emergency 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
- Overhaul your mortgage
- A combination of the above
How much can I save by prepaying my mortgage?
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 about paying off your outstanding loan balance with additional mortgage principal payments, which significantly reduces the total interest you owe over the life of the loan.
Here’s an example of how prepayment saves money and time:
Kaylyn takes out a mortgage for $ 120,000 at an interest rate of 4.5%. The principal and monthly mortgage interest total $ 608.02. Here’s what happens when Kaylyn makes additional mortgage payments:
|* Additional payment of $ 608.02|
|Minimum every month||30 years||$ 98,888||$ 0|
|13 payments per year *||25 years, 9 months||$ 82,870||$ 16,018|
|$ 100 more each month||22 years, 6 months||$ 70,944||$ 27,944|
|$ 50 more each month||25 years, 8 months||$ 82,452||$ 16,436|
|$ 25 more each month||27 years, 8 months||$ 89,864||$ 9,024|
Bankrate’s Mortgage Amortization Schedule Calculator can help you determine the impact of additional payments on your mortgage. Click “Show Amortization Schedule” to display the section that allows you to calculate the effect of additional payments.
DIY extra payment to prepay mortgage
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. You can also refinance your mortgage to completely eliminate the PMI.
Video: Pros and Cons of Prepaying a Mortgage
What are the disadvantages of prepaying my mortgage?
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 13% per year.
When you ask yourself “Can I prepay my mortgage?” »Take a look at your entire financial situation. Here are some important questions to consider:
- Is your monthly budget tight after covering the necessary expenses?
- Is your income variable 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.
What to consider before prepaying 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% to 100% of your contribution, up to a limit (often up to 3% to 6% of your income). This is where the extra money should go first until you are on your way to retirement. Contributions to a pension plan get tax relief and the more time your money has to grow, the better.
- Pay off your debt at a higher rate. It doesn’t make sense to pay off a 4 percent mortgage if you have 16 percent 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 be completely debt free, or do you want your money to work harder for you in another 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.