It takes a certain psychological leap of faith to go ahead and pay extra on your mortgage. After all, when was the last time you sent ComEd an extra fiver with the monthly electricity payment or gave the phone company a check for $10 over your bill?
As smart consumers, it simply goes against the grain to pay more than we have to.
When it comes to a mortgage, though, paying a little more now can save most homeowners a whole lot later.
Consider: On a typical 30-year, fixed-rate home mortgage at today’s interest rates, most homeowners will pay about 2 1/2 times the original loan amount over the term of the mortgage. Simply put: The excess is interest.
“It is pretty simple,” says personal finance author and prepayment guru Marc Eisenson. “You’re paying interest, and the longer you take, the more interest you’re going to pay.”
That said, prepaying on your mortgage is an idea that can save most homeowners money. The key, experts say, is to be regular and steady about it.
One thing you need to understand about prepaying on your mortgage is once the money is sent in and applied to your loan balance, it’s gone. Prepaying an extra month in June doesn’t mean you can skip a payment in December.
There are also a couple of scenarios where you may not benefit from prepaying the mortgage:
– If you have credit card or other high interest installment debt. Before you prepay on your mortgage, pay off other non-tax-deductible debts first, including automobile loans, credit cards and other personal loans, advises Clarence Rose, a professor of finance at Radford University in Radford, Va.
Even credit card debt secured by home equity should be paid off before mortgage prepayment because equity lines generally have a higher interest rate than first home mortgages, he says. In addition to higher interest rates on most consumer debt, the interest expense for such loans is generally not deductible, Rose adds.
– If you aren’t going to live in the house very long–three to five years, say some experts–or are subject to frequent relocation. “Prepaying is an excellent idea, but it really has an impact over a long period of time, not a short period,” says Tom Adams, vice president of Chicago-based Draper & Kramer Mortgage Corp.
– If you’re in a relatively high tax bracket and need the tax writeoff you can get by deducting the amount of mortgage interest you pay, “you’d want to think pretty hard about prepaying your mortgage,” says John Hemschoot, director of home mortgage standards for Washington, D.C.-based Federal Home Loan Mortgage Corp. (Freddie Mac). “The mortgage interest writeoff is one of the last that’s available to most folks.”
Strategies abound for figuring out the correct amount and method to prepay. Experts offer these ideas:
– Round up your payments, suggests Eisenson, author of “The Bankers Secret” (Villard Books, $17.95), which preaches the gospel of prepaying credit cards and mortgages. “The easiest thing to do is pick a number that’s greater than what you have to send each month and send in that much,” he says. Paying an extra $25 per month, for example, can save you $27,814 on a 30-year, $100,000 loan at 8.75 percent interest, he says. Paying an extra $200 per month on the same loan can save you $100,777, which is more than you borrowed in the first place, he says.
– Make a 13th payment each year. At some point during the year, make an extra payment and the entire amount can be credited toward principal reduction. While the actual amount you save will differ based on whether you make the payment at the beginning, middle or end of the year, the difference will be minimal, says Draper & Kramer’s Adams.
– Increase your monthly payment by one-twelfth of your regular payment. Again, this equals out to an extra payment per year, but lets you spread the cash impact out over the course of twelve months instead of having to come up with one extra payment at one time.
– Make the regular mortgage payment plus next month’s principal every single month, suggests Freddie Mac’s Hemschoot. You can get an amortization schedule from your lender and will find the monthly principal amount. So when you write your August mortgage payment, add in the amount of the September principal, and so on down the line. On a 30-year mortgage, you’ll end up saving about 50 percent of the interest and pay off the loan in 15 years, Hemschoot says. “It’s a painless way of doing it, especially in the early years when a consumer might not have a lot of surplus cash,” he says.
While the strategies for just how to prepay your mortgage can be individualized to fit your own cash flow, there are some other general rules to follow.
– Be a regular payer, whether monthly or annually. “To make a prepayment here or there and do it with no regularity or substance accomplishes very little,” says Adams of Draper and Kramer Mortgage Corp. “Prepaying makes all the sense in the world, but people have to understand that it’s the cumulative effect that carries the weight.”
– Make sure your loan doesn’t have a prepayment penalty, says Peter G. Miller, author and host of America On-Line’s real estate forum. A very small number of loans have prepayment penalties, but you need to confirm before you start paying off the loan early, he warns.
– Consult with your lender to make sure any payment above and beyond the monthly amount is applied to your principal, Adams advises. “Sometimes, when (lenders) get extra money and don’t know what it’s for, they’ll put it in escrow where it offers you no benefit,” he says. In recent years, lenders have made this easier by moving to payment coupons that include a box you can check for extra principal payments.
– Don’t buy biweekly consultants. Biweekly mortgages, when offered by a lender, are a legitimate method to reduce your interest payments.
The biweekly mortgage concept works like this: Instead of making one payment per month, you send in a half payment every two weeks. During a 52-week year, that adds up to 26 half payments, which is the equivalent of 13 monthly payments. The extra payment is credited to principal reduction.
The Internet, with its inexpensive marketing capacity, has given rise to a new generation of biweekly mortgage schemes and, in some cases, scams. The newest twist comes in the form of “consultants” who charge to “convert” you to a biweekly mortgage in order to save you “thousands of dollars in interest,” as one Web site boasts.
The consultants charge you $350 to $450 in upfront fees, plus about $3 per biweekly payment to manage your mortgage, including an annual audit. In most cases, they electronically debit your account every two weeks and promise to make sure the lender gets paid. The resulting reduction in principal can, indeed, save you thousands on your interest over the life of the loan.
“The math is correct, but the problem is that you don’t need anybody to do this for you,” says Miller, author of “The Mortgage Hunter” (HarperPerennial, $14). “Instead of investing $300 or $400 in anybody’s service, you ought to just invest it in your principal and lower your interest payments.”
The other issue with biweekly consultants is that they are largely unregulated. “By definition, people who collect mortgage money ought to be licensed, bonded and insured,” Miller says.
If you have access to the Internet, you can calculate the savings that can be achieved by prepaying with free mortgage calculators that are available at Web sites for HSH Associates (www.hsh.com), Mortgage Market Information Service (www.interest.com), Miller’s Our Broker (www.ourbroker.com), or numerous other sites.
At the end of the day, you might also want to keep in mind that mortgage debt is fairly cheap debt. A home is a good, conservative investment that reaps all kinds of rewards, but a big pot of financial gold isn’t necessarily one of them. If you’re debt-free, excluding the mortgage, it might make more economic sense to invest extra wages in a company-sponsored 401(k) plan, says one expert.
Investing in a decent mutual fund through a company 401(k) plan lets you get all the earnings and not have to worry about the taxes until you retire, says professor Jack Ferner of the Babcock School of Management at Wake Forest University.
