What you need to know about prepaying a mortgage. Based on the type of mortgage you have, your loan terms may change.
Q: I saw your video on your YouTube Channel on how making an extra payment on your mortgage pays your loan down faster. When you make an extra payment do you apply all of that to principal or just a normal payment as usual? What if I could pay extra to the loan? Should I apply all of that to principal?
A: You might be a bit confused about how prepaying your mortgage works and what the actual benefits are that accrue when you do that.
Your monthly mortgage payment is made up of what you owe on your loan for the repayment of principal and the payment of interest. For most borrowers, you may also have a payment to the lender towards your escrows for the payment of real estate taxes and homeowner’s insurance. Finally, you may also have to make a payment towards your mortgage insurance.
Let’s start with your escrow payments. Your lender wants to make sure that the real estate taxes on your home are current and paid at all times. The lender also wants to make sure you have insurance in place to pay for the repairs to your home should a casualty hit it.
Now, when you have to pay mortgage insurance, this insurance is only for the benefit of the lender. Mortgage insurance covers the lender in case they foreclose on your home and they lose money on the sale. (Mortgage insurance may only cover part of the lender’s loss, but its only for the benefit of the lender. If you are paying mortgage insurance, it’s because you decided or had to get a mortgage that was greater than 80 percent of your home’s value.)
Depending on the type of loan you have, your principal payment may be fixed for the 15-year or 30-year term of your loan. That means your monthly payment that goes towards principal and interest won’t change during the term of your loan. Your overall payment may change as real estate taxes and insurance costs change, but what you pay towards your principal and interest stays the same amount.
On the other hand, variable rate mortgage products may give you a fixed payment for say 3 or 5 years, but after the initial fixed period, each year after that your payment may change. You should also know that in these products, as interest rates go up or down, the lender reamortizes your loan when the rate changes. The lender must change the amount you need to pay on the loan so that you end up paying off the whole loan at the end of the loan term.
Back to your question, when you want to end up reducing the term of your loan from say a 30-year term and end up paying off your loan after 25 or 23 years, you have to pay the lender extra money towards the principal of the loan. In other words, if you took out a fixed interest loan for $100,000 on a 30-year term, you’ll pay off that loan in full at the end of 30 years. To shorten the life of the loan, you’d have to pay extra to the lender to bring down the principal amount of $100,000.
On a fixed rate loan like this one, you could pay off $20,000 the day after you took out the loan, that would shorten the loan by quite a number of years. Your monthly payments are fixed so you’ll need less of those payments to pay off the $80,000 than you would to pay off $100,000. So, to your question, your extra payments must always be made to reduce the principal on your loan. On your coupon book, you may see a line item where you can write in the extra amount you are paying to reduce the principal balance on your loan.
As a side note, if you pay down the principal on a variable rate loan when the lender reamortizes your loan to reduce your loan payments but you’ll still end up with a 30-year loan term. The only way you can reduce the term is to continue to prepay the principal on the loan, continue to make the same payments as the interest rate goes down and pay the higher payment as interest rates go up plus the extra amount you want to apply towards principal on the loan. As you reduce the principal on the loan and if interest rates stay about the same or go down over the life of your loan, eventually your monthly payments may be so small that you can make one final payment to the lender to pay off the loan early.
The only exception to this with adjustable rate mortgages is when interest rates are going up and if your payments to reduce the principal on your loan don’t significantly reduce the loan balance you owe, you’ll still end up paying monthly payments to the lender for the entire term of the loan, but any reductions on principal payments you would have made should have saved you on the amount of interest you paid over the life of the loan.