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PublishedNovember 8, 2015 | min. read
Karin Price Mueller Karin Price Mueller is an award-winning writer and money expert. ... Read More
Q:I have paid almost $6,000 extra toward my mortgage principal. Isn’t my new payment supposed to go more toward principal and less for interest for the next payment?— Paying it down
A:Here’s how it works.
When you took out your mortgage, assuming it was a fixed-rate loan, there was an amortization schedule set by the lender. That schedule doesn’t change during the life of the mortgage, said Jim McCarthy, a certified financial planner with Directional Wealth Management in Rockaway, N.J.
“Your interest payments are based on your outstanding loan balance, not on your monthly principal payment,” McCarthy said. “If you pay next month’s principal payment, you will save a little interest, but not that much because your overall balance hasn’t been reduced by that much.”
For example, if the mortgage interest rate is fixed at 4.5%, a month’s worth of interest on a $100 prepayment of principal is 37.5 cents, McCarthy said.
But, he said, if you keep making additional principal payments every month, you can significantly reduce your interest payments over time.
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While you may want to pay down your mortgage faster, it may not be the best overall strategy for your finances.
Keeping extra cash on the side —having liquidity — may be more beneficial in the long run, said Jerry Lynch, a certified financial planner with JFL Total Wealth Management in Boonton, N.J.
“Problems always happen, and you always need a Plan B,” Lynch said. “If you lose your job or get hurt, the bank does not care that you paid them an extra $6,000 last year and you can’t get it back.”
The lender wants your monthly payment when it’s due, so you need to make sure you have savings to cover you in an emergency.
Lynch said rather than prepay the mortgage, he’d prefer to see you invest that extra cash monthly in a taxable account that takes on only moderate risk.
“With a 4% mortgage and a 30% tax bracket, we only need to beat 2.8% on an after-tax basis to have more gain in that side account,” he said. “If you have a problem, you have access to the funds, and at the end, after you have this fund for a while, you can always liquidate the account and pay off the mortgage.”
If you already have that kind of liquidity, then Lynch said paying down the mortgage is a fine strategy. Just make sure you have access to cash first.
More on Mortgages & Homebuying:
- Why You Should Check Your Credit Before Buying a Home
- How to Refinance Your Home Loan With Bad Credit
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FAQs
If you can afford to pay off your mortgage ahead of schedule, you'll save some money on your loan's interest. In fact, getting rid of your home loan just one or two years early could potentially save you hundreds or even thousands of dollars.
What are 2 cons for paying off your mortgage early? ›
However, there are also potential drawbacks to consider:
- Liquidity Concerns. Prepaying your mortgage ties up your funds in your home, potentially leaving you with less liquidity for other financial needs or opportunities.
- Lost Tax Benefits. ...
- Opportunity Cost. ...
- Prepayment Penalties.
Prepayment risk refers to the risk that the principal amount (or a portion of the principal amount) outstanding on a loan is prematurely paid back. In other words, prepayment risk is the risk of early repayment of a loan by a borrower.
Is it smart to pay ahead on mortgage? ›
Paying off your mortgage early can save you a lot of money in the long run. Even a small extra monthly payment can allow you to own your home sooner. Make sure you have an emergency fund before you put your money toward your loan.
Why do lenders not like prepayment? ›
Lenders dislike prepayments because they lose out on interest charges. Prepayment essentially shortens the term of the loan, which means less interest paid. If enough borrowers prepay their loans, lenders also face increased interest rate risk, meaning the potential for investment losses.
What is the smartest way to pay your mortgage? ›
Instead of making a single payment each month, you can pay half of your monthly mortgage payment every two weeks. In doing so, you'll end up making one extra payment per year. In our example of a $400,000 mortgage with a 7.04% APR, making biweekly payments would reduce a 30-year repayment term by more than six years.
What are the disadvantages of prepayment? ›
Disadvantages of Prepayment meters
If your prepayment meter has run out of credit and your supply is off, you may need to repay any 'Emergency Credit', 'Friendly Credit' or any outstanding amount owed, before your supply will come back on. You may also need to account for any debt repayment plan that has been agreed.
Why is prepayment bad? ›
Prepayment risk is the risk involved with the premature return of principal on a fixed-income security. When prepayment occurs, investors must reinvest at current market interest rates, which are usually substantially lower. Prepayment risk mostly affects corporate bonds and mortgage-backed securities (MBS).
How much prepayment is allowed on mortgage? ›
What's a closed mortgage? You can't prepay, renegotiate or refinance a closed mortgage before the end of the term without a prepayment charge. But, most closed mortgages have certain prepayment privileges, such as the right to prepay 10% to 20% of the original principal amount each year, without a prepayment charge.
What happens if I pay an extra $200 a month on my mortgage? ›
If you pay $200 extra a month towards principal, you can cut your loan term by more than 8 years and reduce the interest paid by more than $44,000. Another way to pay down your mortgage in less time is to make half-monthly payments every 2 weeks, instead of 1 full monthly payment.
Dave Ramsey, the renowned financial guru, has long been a proponent of financial discipline and savvy money management. This can include paying off your mortgage early, but only under specific financial circ*mstances.
What happens if I pay $1000 extra a month on my mortgage? ›
When you pay extra on your principal balance, you reduce the amount of your loan and save money on interest. Keep in mind that you may pay for other costs in your monthly payment, such as homeowners' insurance, property taxes, and private mortgage insurance (PMI).
Is there a benefit to paying a mortgage early? ›
By reducing the length of time you spend making mortgage payments, you'll cut down the amount of interest you pay over the life of the loan. Depending on the loan amount, interest rate and original term, paying your mortgage off early could result in significant savings. Free up money for later in life.
How can I pay off my 30 year mortgage in 10 years? ›
Here are some ways you can pay off your mortgage faster:
- Refinance your mortgage. ...
- Make extra mortgage payments. ...
- Make one extra mortgage payment each year. ...
- Round up your mortgage payments. ...
- Try the dollar-a-month plan. ...
- Use unexpected income. ...
- Benefits of paying mortgage off early.
