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Prepaying Your Mortgage

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If you’re looking for a way to reduce your debt — or say goodbye to your monthly mortgage payments at an earlier date — you may be considering prepaying your mortgage.

Mortgage prepayment can make sense for some borrowers, but it’s important to take into account your personal financial situation as well as the overall economic environment. We are currently in a lower interest-rate environment overall, even as rates have been rising somewhat, so it may not be worth putting so much money toward your loan now. However, it may be worth it for you to offload some debt.  Here’s a look at some of the pros and cons of choosing to pay a mortgage ahead of schedule.

What is mortgage prepayment?

Mortgage prepayment means paying off all or part of your mortgage ahead of schedule. There are a number of ways to go about doing this.

Lump sum. This means paying off some or all the remaining balance on your mortgage in one chunk. For example, if you receive a sudden inheritance or other windfall, you may decide to put it toward your mortgage.

Increase the size of your monthly payments. Some homeowners choose to pay extra money on their principal every month, which will both reduce the amount of interest owed and decrease the length of time left on the mortgage. This additional amount can be big or small, with some borrowers simmply rounding their monthly payment up (for example paying $1,600 a month when the monthly payment is $1,550).

If you choose to make an extra lump sum or monthly payment, be sure to tell your lender that you want the additional payment taken off the principal and not just applied to next month’s balance. This can be done in person, in writing, by phone or online for some lenders.

Biweekly Payments. Some lenders offer biweekly mortgage payment plans. With these plans, you make half your monthly payment every two weeks. As there are 52 weeks each year, you’ll make the equivalent of 13 monthly payments each year and pay off your mortgage faster. In theory, a biweekly payment plan also reduces your interest because you are paying off your principal at a faster rate.

However, there are some red flags to watch for with biweekly plans. Sometimes there are fees involved, or the lender will actually just hold onto the first payment and wait to apply it to the principal until the second one comes, which reduces the savings for you. It may make more sense to just make extra payments toward the principal, rather than using a biweekly plan. Learn more about biweekly payment plans here.

Refinancing Another way to prepay your mortgage is to refinance. Refinancing to a shorter- term loan means you’ll pay off the mortgage faster. Alternatively, refinancing to a lower interest rate could give you extra savings each month to apply toward the loan principal.

Only a small percentage of loans are paid early. Data firm Black Knight found prepayments fell to near a 10-year low in November and December 2018, to 0.66% of mortgage debt. This includes mortgages paid early due to home sales, which made up more than a third of the total in November.

The benefits of prepayment

Saving on interest. Paying your mortgage ahead of schedule can save you serious money when it comes to interest charges. For example, let’s say you have a $200,000, 30-year fixed mortgage at 4.5%. Imagine that, with 25 years left, you start paying $100 a month extra off the principal. Over the life of your loan, you’ll save $20,806 and shave three years and nine months off the length of the mortgage.

Building home equity. The more of your mortgage principal you pay off, the more equity you’ll build in your home. If you already have savings and a balanced portfolio of investments, building home equity can be a way to diversify your investments.

Peace of mind. A major motivation for many people to pay down their mortgage early is more emotional than financial. Some borrowers hate holding debt or find it stressful and prefer to have their mortgage paid off as soon as possible.

“If paying off that mortgage will help you sleep at night, that’s well worth it,” said Angela Dorsey, a certified financial planner who runs Dorsey Wealth Management based in California.

Saving on PMI. For borrowers paying private mortgage insurance, prepaying the loan can help eliminate that cost faster. The sooner the debt-to-equity ratio on the loan falls below the 80% threshold, the sooner the homeowner can cancel the PMI and say goodbye to the monthly fees involved.

Potential pitfalls

Less money for other higher-return investments. Interest rates remain low by historical standards. A borrower with excellent credit can still get a 30-year fixed mortgage with an APR below 4.5%. Over the long run, you may earn a higher rate of return investing in a wide range of stocks. Depending on the terms of your mortgage and the time frame, it might be a better choice to park your additional cash in an investment account of stocks and bonds instead of in your home.

Dan Estal, vice president of lending and market development at Northern Credit Union in Watertown, N.Y., said a well-diversified portfolio should override the borrowing costs on today’s mortgages. Estal recommends you take your age and investment horizon into account when weighing your options but also said it only really made sense to prepay if the mortgage is your last debt and you can’t find a more lucrative investment vehicle.

Ties up equity. A home is not a very liquid investment. Once you sink a lot of cash into a house, it’s not that easy to access again. Getting a home equity loan or HELOC can be time-consuming and expensive.

“You don’t want to be house poor, where all of your assets are in the ground, in your house and you don’t have the liquidity,” said Dorsey. She tells clients to make their top priority saving for retirement before prepaying the mortgage.

Consider if you might need money for an upcoming expense, such as a child’s education, a wedding or an unexpected emergency. If so, putting it toward your mortgage principal may not make the most sense for you.

Failing to pay down other debt. Credit cards and personal loans generally charge much higher levels of interest than mortgages, and the interest payments are not tax-deductible. If you have outstanding debts, you can save money by paying them off before you consider prepaying your home loan.

Prepayment penalties. Some mortgages will charge a penalty if you prepay some or all of your loan ahead of schedule. These charges must be disclosed when closing on your loan, and typically only apply if you pay off all the mortgage in a few years, or pay a very large chunk. Federal regulation limits the type of mortgages that can charge prepayment penalties. For example, they are not allowed on adjustable-rate mortgages. Estal said prepayment penalties are no longer common and Northern Credit Union doesn’t charge them, except on very specialized products like no closing cost mortgages. You still should check with your lender just in case.

How to know if prepayment is right for you

Do the math. Online calculators such as this one can help you calculate exactly how much money you’ll save in interest if you make larger mortgage payments each month, as well as figure out how much earlier you’ll be done paying off your mortgage.

Look at your mortgage terms. Make sure you understand the terms of your mortgage, including what your total APR is and whether there are any fees or penalties for prepaying.

See the big picture. “I really encourage people to look at their total finances,” Dorsey said. It might be more logical for a homeowner planning to retire in the next few years to pay down their mortgage in order to reduce expenses, she said, in comparison to a younger person who should be probably be putting it toward savings.

When deciding, you need to think not only about your current income, spending and savings, but also future plans and needs. Take into account whether you have enough emergency and retirement saving,s and what your long-term financial plans are. Compare the cost of the mortgage to potential financial returns from other investments. Also, consider your emotional relationship with debt and how it impacts your life.

Bottom line

There are a lot of factors at play when it comes to deciding whether to prepay your mortgage. Low interest rates make prepaying less attractive for many borrowers, and you should consider what other investments are available for your cash. But in the end, the decision is a very personal one, and depends on factors unique to your particular situation.

This article contains links to MagnifyMoney, a subsidiary of LendingTree.


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