Q: In your columns, you frequently say that by making an extra payment each month, you will shave 6 to 8 years off of your 30-year mortgage. Is this still true in this era of extra-low interest rates?
I just bought my first house (as a senior), and while I took out a 30-year mortgage at 4.75 percent to keep my payments low, I want to know how I can pay off the house sooner. My loan amount is $118,500 and my monthly payments are $619.
A: I’m glad you asked. One of the great benefits of prepaying your mortgage is that each prepayment is applied toward the principal of the loan. Since you’re paying interest on what you’ve actually borrowed, paying down the loan faster than prescribed in a 30-year amortization schedule means you’re paying less interest overall.
Prepaying your mortgage works best when interest rates are higher than they are now. That’s because you’re paying more in interest and the way compounding works, you’re saving a bigger amount of money by prepaying.
For example, let’s say that your $118,500 loan was actually at 7 percent, rather than 4.75 percent. Your monthly payments would be around $788 per month. Making one extra $788 payment per year would slice a 30-year loan to 24 years. Making two extra payments per year would cut your loan term to 21 years.
But prepaying your mortgage will work even if you have a 4.75 percent interest rate.
If you take your $619 per month payment and divide it by 12, and then make a 1/12 payment (about $52) each month toward the principal, you’ll cut your 30-year mortgage to 26 years. You may save a month or two of payments if you make one extra $619 payment at the beginning of each year rather than doing monthly installments.
If you make a $60 per month prepayment, you’ll cut the loan to 25 years. If you prepay $125 per month, you’ll cut the loan to about 22 years.
The best way to prepay your mortgage is to simply attach a second check for the prepayment amount. Write “Use to prepay balance” in the memo section and be sure to check off the box that says “prepayment amount” on the coupon your lender sends you. If you don’t have a payment coupon, be sure to enclose a note with the checks so there is no confusion.
When your lender sends you your statement at the end of the year, be sure to check that your prepayments are noted. You’ll have better luck keeping track if you keep all of your prepayments the same inside a single year rather than sending in $35 one month and $400 the next.
Here are some other issues to think through before you start prepaying your mortgage. First, should you prepay your loan? The interest rate on your loan is historically quite low and, as such, some experts have argued that you shouldn’t prepay the loan if you expect inflation to be quite high in the future or higher than the interest you are paying on your home. If you repay your loan at a later date using money that has been invested in an investment that earns more than you have to pay your lender, you will take advantage of the low loan interest rate and the higher bank interest rates on the market. While that may be true, many of us might fail to invest in the right places at the right time. For many of us prepaying the debt give us an assurance that the money we put in is somewhat safe in the equity of our home and in the reduction of our debts.
Finally, make sure you can afford to make those extra payments to reduce your loan. For some homeowners, if their budget is tight, prepaying their mortgage would shoot a hole in their monthly budget. For others, prepaying their mortgage gives them a sense of reducing the amount of debt they have, and is a form of enforced savings.
May 28, 2009