When you prepay your mortgage, you pay off the full loan amount before the due date to save money on interest payments. You can do this by paying extra on your mortgage each month or by making an extra payment or two each year.
Refinancing is also considered a form of prepayment since you pay off your current loan and replace it with a new loan, often with a lower interest rate or shorter term. Over the life of this new loan, you should save enough money on interest to make paying the closing costs that may be associated with the refinance worthwhile.
Regardless of how you choose to prepay your mortgage, it’s important to understand how much money you might save and if prepaying makes sense for you. Think about these questions before you decide!
Does your mortgage have a prepayment penalty?
Before you make extra payments or refinance, check to see if your mortgage has a prepayment penalty. This information should be in the Note or other loan documents you received when you closed on your house. Some mortgage lenders charge a prepayment fee and you’ll want to know how much since this penalty will reduce the amount of money you might save. Some prepayment penalties only apply for the first years of the loan’s term. If you’re close to reaching the end of the prepayment penalty term on your mortgage, it may be better to wait.
How much money will you save?
The amount of money you might save depends on many things, including the type of loan product (fixed rate or adjustable rate), the loan term (15, 20 or 30 years), your interest rate, the amount you owe on your mortgage and the amount of the extra payment(s) you are able to make toward the principal. Consider this example for a 30-year fixed rate mortgage with an interest rate of 4%.
|Without making extra payments toward the principal balance of the mortgage||With extra payments made toward the principal balance of the mortgage|
|Monthly principal and interest payment**||$1,074.18||$1,074.18|
|Extra monthly payment made toward the principal balance of the mortgage||$0.00||$125.82|
|Total monthly payment (including additional payments made toward the principal balance of the mortgage)||$1,074.18||$1,200.00|
|Total potential savings on interest by making extra payments***||$0.00||$33,020.21|
|Time to pay off loan||30 years||24 years, 7 months|
*Rate is an example only and may not reflect either your current interest rate, or the rate that is currently available.
**You may also be required to make monthly escrow payments for taxes and insurance as part of the mortgage obligation. Actual payment obligation may be greater.
***The amount of savings will vary over time depending on individual circumstances. The longer a consumer retains the property and loan at the stated rate, the more interest savings will be realized.
Keep in mind the longer you stay in your home, the more money you may save by paying extra or refinancing your mortgage. If you are only going to live in your house another couple years, you aren’t likely to save much money. If you plan to live in your house a long time, like in the example above, then you could save quite a bit.
Is making extra mortgage payments the best use of your money?
Before you pay extra on your mortgage, decide if paying more on your home loan is the best use of your money. For example, financial professionals generally recommend that you pay off higher interest debts before you pay off lower interest debts. So if you have $5,000 in credit card debt with an interest rate of 17%, you probably want to pay off this debt before you start making extra payments on a mortgage with an interest rate of 4%. If you are saving for college or retirement, you might decide it is better to put the money in these investments. And if you don’t have an emergency fund for home repairs or other bills, you might want to build up your rainy day reserve before you pay extra.
Refinance versus making extra mortgage payments
A refinance or paying extra each month are two ways to prepay your mortgage. Each has advantages and disadvantages. One advantage of a refinance is that you can get a different interest rate. Financial professionals generally recommend thinking about a refinance when current interest rates are at least 0.50% lower than the interest rate on your mortgage. That’s because you are likely to pay new closing costs when you refinance, and you need to balance these new costs against the amount of money you might save with a lower interest rate.
When you pay extra money on your mortgage each month, you don’t have the opportunity to pay a lower interest rate but you also don’t have to pay the closing costs on a new loan either. You also aren’t committed to paying more on your mortgage bill each month. Sometimes when people refinance, they shorten the term of their loan from 30 years to 15 years. This can save them money, but it also can increase their minimum monthly payments. They might be required to pay more every month. When you decide to make extra payments on your current mortgage, you can pay as much or as little extra as you want each month – including nothing extra at all.