If you're making monthly payments on a home mortgage and finding yourself with extra cash at the same time—perhaps because you’re making more money than when you first bought your house—paying more of the principal you owe can offers many financial benefits. The idea is that, while keeping the same mortgage on the same terms, you simply elect to add extra dollars onto your payment, whether on a one-time basis, off and on when you feel like it, or on a disciplined, regular basis.
(Don’t even think about doing this, however, if you have other high-cost debts to pay off! Credit card interest rates typically run at double or triple that of most home mortgage loans. Any extra cash you bring in should go toward paying off those balances first.)
Although your mortgage company has carefully worked out a calendar of payments, the amount of interest owed is always based on the remaining unpaid principal. In other words, it can change over time if you pay more principal than your lender expected you would.
The result is that by making prepayments, you can shave thousands off the interest you’ll pay in the long term. This is particularly true if you prepay in the early years, when your scheduled payments are probably made up of far more interest than principal.
For example, if you have a $300,000 mortgage at 5.5% on a 30-year, fixed-rate mortgage, and you make the minimum payment, you’ll pay about $313,000 in interest over the life of the loan. But by paying just $100 extra each month, you’ll pay the loan off almost four years earlier and spend only about $267,000 on interest. To run these numbers for your own mortgage, go to a calculator called How much will I save by increasing my mortgage payment?
While you’re at it, if your down payment was low enough that you had to purchase private mortgage insurance (PMI), paying down the mortgages early will help you end this obligation.
Prepaying your mortgage also gives you future freedom. Eventually, if you keep up your prepayments, you’ll pay it off entirely. With this shorter mortgage term, you’ll know that you can remain in your home for the ensuing years with no threat of losing it to a bank. And you no doubt have plenty of ideas for spending that money!
So what’s the downside? Money spent prepaying your mortgage cannot be invested or spent on other things. For example, if you know you want to remodel your kitchen in a few years, and would have to borrow money and pay interest to do so; or worse yet, planned to put a lot of the work on a credit card; it might make more sense to save and invest the money you’d otherwise spend on prepayments.
Also, you’ll need to balance your retirement goals against prepaying your mortgage. First off, if your employer matches contributions to a 401(k), you don’t want to turn away that free money.
Also take into account what you might earn by investing the money. The earlier you start saving, the more your money will grow by the time you’re retired, thanks in part to the power of compound interest: As you earn money on your investment, that cash is reinvested, earning interest on interest.
Another important financial consideration is protection against risk of job loss, death, or disability. If you have dependents, for example, you might want to buy life insurance. Disability insurance is also a good way to protect against unexpected health issues. And if you haven’t yet put aside an emergency fund (a savings set-aside that will cover your expenses for six months to a year if you lose your job) that should probably take first priority.
Also realize that the financial benefits of prepaying a mortgage are, on balance, reduced a bit if you can deduct mortgage interest from your taxes.
Talk to a financial adviser for a complete analysis.