You’ll often hear people ask whether they should prepay their mortgages, and for many it makes sense to prepay.
Q: I hear and see so many financial advisors and experts recommending that people pay off their mortgages by making an extra mortgage payment each year. The reality is that it would be easier for the average person to include an extra $83.34 on a $1,000 mortgage payment than to come up with an extra $1,000 at the end of the year. What the heck, round it up to an extra $85!
While it makes sense to make extra payments now to reduce the principal on a high interest loan, it is very likely future inflation will make the prospect of paying extra dollars now (which are dear) to save cheap dollars later a bad business proposition.
A: You’ve made two very good points.
First, you say that people are better off rounding up their payments to pay down their home mortgages because they will probably not have the money at year’s end to make that extra monthly payment. We agree. If you don’t have the financial discipline to save money in a separate during the year to pay down your mortgage balance, you are better off rounding up your payments on a monthly basis.
Not only are you better off because you don’t have to worry about it at the end of the year (at the holidays, when cash is extremely tight for most families), but you’ll get an increased benefit by paying down your mortgage throughout the year. Any payment that reduces principal faster means you’re paying less interest on that borrowed sum the following month. So even more of your monthly payment goes toward repaying your principal.
The bottom line is that any increased payment towards your mortgage will save you interest in the long term – at least when it comes to fixed-rate mortgages.
Now if you are not able to save much money during the year, it’s unlikely that you have the discipline to invest your money, it’s more likely that you are spending all that you have. For this type of person, saving on his mortgage payments is probably better in the long term, even given your excellent second point: the corroding power of inflation.
You are correct that with historically low interest rates available, now is a good time to borrow money. In fact, as we were writing this, Freddie Mac’s weekly mortgage survey found that 30-year fixed rate mortgages were available for under 3.85 percent.
Financially-savvy homeowners borrow when interest rates are low and use that cash for other investments. If interest rates increase over time, you may find yourself with borrowed money at 3 percent or less (if you opt for a 15-year mortgage) when interest rates and inflation are more than that. At that future date, you will be ahead of the time when you borrowed the money.
If you borrow $100,000 today at four percent and put money into a savings account you might be lucky to get up to one percent per year on that money. So you’d be losing about 3 percent on that money per year. But if five or ten years down the line, interest rates go up to 8 percent and savings accounts pay 5 percent, you’d be making one percent on the money you borrowed without doing much of anything and taking virtually no risk.
Having said that, it seems that you have to consider each person’s ability to borrow and invest and their ability to save. Since many people are unable to save for a rainy day and less so to save for retirement, paying down their mortgage is a safe way to put money into their home, pay down their debts, and get to the day when the mortgage on a person’s largest asset is paid off. This is how most Americans have traditionally built wealth.
However, if you are underwater on your mortgage, paying down the debt may not be a solution, particularly if you are planning to sell in the near future or are heading into foreclosure. The dynamics of paying down your mortgage may work better for homeowners that have equity in their homes.
Thank you for your comments.
One very important point I never hear mentioned, is what the lender does with the extra payment(s). If you pay extra on your mortgage in advance does the lender require that the next payment be paid on time or can you simply delay paying some payments until the total paid-in agrees to the payments due. It would seem that many payoff amounts calculated at some point in the future by the lender, might go back to the original recorded security deed and original amortization schedule with the extra payments overlooked. Is the lender expected to recalculate the amortization schedule each time payments are made in advance. Who keeps track of advance payments and how are they treated in the calculation of interest and principal remaining on the mortgage. How would a homeowner take exception to how the lender records the payment. If the amortization schedule is not followed, how is the interest for income tax purposes reported by the lender.
You always have to make your monthly mortgage payment on time. If you make it too early in the month, it’s possible that the lender will assume it’s a prepayment of the balance, will apply it that way, and then ding you for a late payment. That’s why we always suggest making prepayments separate from your regular monthly payment You can put it in the same envelope, but use a separate check that is marked “apply to loan balance.”
Reamortization doesn’t happen when you prepay unless you make a substantial prepayment, perhaps $50,000 all at once. The other time you’ll get a reamortization is if you’re in an adjustable rate mortgage. When the interest rate adjusts, the loan is reamortized to reflect the new payment.
You should keep track of the extra payments you’re making and you should see that reflected at the end of the year in your statement. (Sometimes lenders will show it on the next month’s statement, but all of the payments should be shows in the year-end statement.) The interest that you pay each year is tracked by the lender and will be provided to you in a 1099 as the next year begins. If you suspect that your lender has incorrect figures, you could hire someone to do an accounting of transactions and figure it out.
Hope this helps. Thanks for visiting ThinkGlink.com.