Buying a home is one of the biggest investments you will make in your lifetime, but do you want to be paying for it for the rest of your life? Probably not. Which begs the question: If you have the means, is prepaying your mortgage a good idea?
Most of the time, it is. You will save a substantial amount of money in interest, shorten the length of the loan term, increase the equity you have in your home and own it outright sooner. But before you start writing checks to your mortgage company, there are a few things to consider to ensure that your money wouldn’t be better used elsewhere: Do you have any debt? Is your retirement plan on track? Do you have an emergency savings account?
If you do have debt, aren’t maxing out your retirement account contributions or don’t have between six months to a year’s salary in your emergency fund, then prepaying your mortgage isn’t something to consider just yet. But if you’re in good shape financially, consider this.
By making just one extra mortgage payment per year, you could substantially reduce the total cost of your loan. For example, if you borrowed $100,000 on a 30-year loan at 4 percent, your monthly payment would be $477. If you make 13 payments a year instead of 12, you would save over $10,000 in interest over the life of the loan and reduce your total loan term by four years. (You can use the calculator at Bankrate to see how it would affect your loan). And if you double your mortgage payment, you could pay off that same 30-year loan in only 11 years.
When you’re writing a check to the bank for the extra payment, it’s important to mark on it that you want it to be applied to the principal. If you don’t, the bank might apply the extra payment to interest, and paying interest in advance does not earn you any more equity in your home. But do your homework. Prepayment penalties — which can be owed to a lender for prepaying a mortgage within a specified time period — are much less common than they were before the Great Recession, but do still apply in some cases (although typically just during the first two to four years of a loan).
Remember that prepaying a mortgage isn’t the best option for everyone. And in addition to making sure that your other higher-interest, non-deductible debts are paid first and your retirement and emergency savings accounts are in order, there are a few other reasons why you might not choose to prepare your mortgage:
- Your interest rate is extremely low. If you were lucky enough to refinance into a 30-year fixed-rate loan at 4 percent or below, that’s a historic interest rate. You might want to keep that rate and use your free cash for something else, like…
- You’ve found other investments with a higher rate of return. You might decide to invest your savings in the stock market or another investment that has a higher rate of return over time. Or, you might decide to buy investment property.
But if neither of these scenarios apply to you, go ahead and apply a few extra payments to your principal this year. The less time it takes you to pay off your loan, the more money you’ll save in the long run.