Paying off a mortgage is a tremendous milestone in life. Most of us yearn for the day when we won’t need to make those monthly payments anymore. It’s not surprising then, why so many people consider the option of prepaying their mortgage. Even if a mortgage is considered ‘good debt’, what’s not to love about the idea of paying it off more quickly? The truth is that deciding to prepay your mortgage isn’t as simple it may seem.
Before you think about paying your mortgage off early…
The first step is to actually check with your lender to see if there are any penalties or fees associated with prepayment. Yes – sometimes trying to be a proactive, responsible borrower can bite you in the ass. So check your mortgage contract for prepayment penalty or fee clauses. If prepayment penalties exist in your contract, they are typically applied within the first few years of the mortgage. While these fees are pretty rare these days, it is still worth your time to check.
Prepayment penalties can be costly and should not be ignored. In some cases, prepayment penalties may defeat the entire purpose of trying to save yourself some money and pay off a mortgage early, so it pays to do your homework.
How do you actually prepay your mortgage?
If you’ve determined that your lender won’t assess any prepayment fees or penalties, the next step is to ensure any additional payments will go towards the principal of your loan (and not towards interest). Moving forward with those assumptions, there are three basic ways you can prepay your mortgage:
1. Make an extra lump sum payment
Perhaps you received an inheritance or other form of unexpected income. You could take that money and apply it directly to your mortgage in a lump sum payment.
2. Overpay your monthly mortgage payment each month
Maybe you’ve received a salary increase or simply determined you can afford to pay more each month. A second option for mortgage prepayment is to pay a little more than your actual monthly payment. For example, if your monthly mortgage payment is $1400, then you could pay $1500, meaning you’re prepaying an additional $100 towards your principal each month.
3. Make one additional mortgage payment each year
Making one additional mortgage payment each year will reduce your interest paid substantially. Some borrowers choose to make an extra payment when they receive their tax returns in the spring. It’s not a bad way to put your money to good use without feeling like your checking account is taking a big hit.
What are the benefits of prepaying your mortgage?
There are essentially two upsides to prepaying your mortgage. Remember, this is assuming two things. One: you have the ability to prepay with no penalty or fees. And two: that your prepayment can be put towards the principal of the loan.
You’ll pay less interest overall
When you have the ability to prepay your mortgage you’ll end up paying less interest over the lifespan of the loan. In simple terms, it means you’ll actually pay less to own your home by paying less total interest.
You’ll pay your mortgage off faster
When you pay off your mortgage early, it will increase the equity you have in your home earlier on, and you’ll own your home outright sooner. Of course, it also means you’ll be done paying monthly mortgage payments earlier. Let’s look at a few comparisons to help paint the picture.
Below is a table representing four payout structures for a 30 year $300,000 mortgage at 4.0% interest. The first row represents no prepayment. The second row represents an additional $100 monthly prepayment. The third represents paying an additional mortgage payment each year. And finally, the fourth row represents making a one time lump sum payment of $10,000 made at the end of the first year of the mortgage.
Where the differences lie
You’ll notice that there isn’t a tremendous difference between these options in how long it will take to pay off your mortgage. Shaving a few years off your mortgage is certainly an accomplishment. However, the real difference lies in how much interest you’ll end up paying.
Notice that if you prepay an additional $100 per month on your mortgage, you’ll save almost $29,000 in interest over the course of your mortgage. This is why so many people consider prepaying their mortgages. But, while saving almost $29,000 in interest seems impressive, it still may not be the best way to put your money to work.
Why prepaying your mortgage might not be in your best interest
Overall financial stability is more important
To start with, many of us don’t have the flexibility to dole out an additional $100 a month towards our mortgage. Even if you do, it might require you to tighten your financial belt past your comfort level. You certainly don’t want to consider prepaying your mortgage unless your emergency fund and savings accounts are healthy enough to continue handling unexpected expenses that will inevitably pop up.
Opportunity cost is the loss of a potential gain you may have realized had you chosen an alternative. In the context of mortgage prepayments, you might compare the opportunity cost of prepaying your mortgage instead of investing that money in the stock market.
Recall the almost $29,000 you would save by prepaying your mortgage by $100 each month. What if instead, you invested that $100 per month in the S&P 500? Over the past 90 years, the S&P 500 has averaged a 9.8% annual rate of return. Investing that $100 a month for 30 years would grow to an estimated $190,068.84. That’s a lot better than saving $29,000.
It might make more sense to refinance
Prepaying your mortgage isn’t the only option if you’re looking to make your money work for you, while also paying less interest on your mortgage. In certain circumstances, it may make more sense to refinance your mortgage. There are a number of reasons to consider refinancing, including obtaining a lower interest rate, shortening the term of the mortgage, or switching from an adjustable-rate to a fixed-rate (or vice versa).
Typically, one of the most advantageous reasons to refinance is to lock in a better interest rate. Many people consider refinancing for the same reasons they consider prepaying their mortgage. Both provide an opportunity to acquire lower interest rates, pay less in interest overall, and build equity more quickly.
However, there are costs associated with refinancing. These costs typically fall in the range of 2%-5% of the loan’s principal amount. So, refinancing to lock in a better interest rate only makes sense if what you save will offset the cost you’ll pay to refinance your mortgage. As a general rule of thumb, if you can improve your interest rate by 1% or more, it’s worth considering refinancing.
The bottom line
With every financial decision comes an opportunity cost. Ultimately, you need to decide which opportunity will provide you the best yield. Paying less in interest and getting rid of those monthly mortgage payments sooner rather than later is enticing. But, it’s worth your time to do your homework and determine if prepaying your mortgage is the right decision for you and your family.
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