Overview: Paying Off Your Mortgage Early
Every time you make a mortgage payment, its split between your principal and your interest. Most of your payment goes toward interest during the first few years of your loan. You owe less in interest as you pay down your principal, which is the amount of money you originally borrowed. Most of your payment goes toward interest during the first few years of your loan. You owe less in interest as you pay down your principal. At the end of your loan, a much larger percentage of your payment goes toward principal.
You can apply extra payments directly to the principal balance of your mortgage. Making additional principal paymentsreduces the amount of money youll pay interest on before it can accrue. This can knock years off your mortgage term and save you thousands of dollars.
Lets say you borrow $150,000 to buy a home at 4% interest with a 30-year term. By the time you pay off your loan, you will have paid a whopping $107,804.26 in interest. This is in addition to the $150,000 you initially borrowed.
Now, lets say that you pay an extra $100 every month toward a loan with the exact same term, principal and interest rate. At the end of the term, you will have paid $82,598.49 total in interest. Thats $25,205.77 less than you would have paid if you didnt make any extra payments. Youll also pay your loan off 74 months earlier than you would if you only paid your premium each month.
What If Your House Produces A Rental Income
As we mentioned earlier, one of the only avenues where it would be possible to get a tax deduction on your mortgage interest would be to using your house or condominium for rental purposes. In other words, you would need to turn your home into an investment property. For example, if you rent out one or more of your rooms, or need to renovate to make a basement suite more livable, then earn an income from a new tenant, or tenants, your expenses count as rental related, and you should be able to claim them on their taxes. However, if your property, whether the property is a house, apartment or a condo, does not generate any revenue from a business or rent, you will not be entitled to any tax deductions.
What Happens When You Make A Lump
When you make a lump-sum payment on your mortgage, your lender usually applies it to your principal. In other words, your mortgage balance will go down, but your payment amount and due dates won’t change.
Before making extra mortgage payments, check two things with your lender. Make sure there are no prepayment penalties, and confirm that your extra payments will be applied to your principal balance, not toward interest.
You could send in an extra mortgage payment every month, but you’ll still be required to make a mortgage payment the following month. The only thing that changes is that you’ll pay off your mortgage sooner than you’d originally planned, and you’ll save money on interest, to boot.
For example, let’s say you’re five years into a 30-year mortgage at a 3.5% annual percentage rate , with a $500,000 balance remaining. If you used a $10,000 lump sum to pay down your mortgage, you’d shave off 10 monthsand $13,500 in interestfrom your original payment plan.
However, your normal monthly payment would still be due the next month. You can’t pay ahead on your mortgage to take breaks on your payments later if you run into a tough financial patch. If you’re worried about being able to make your payments in the future, though, another option might help you: recasting your mortgage.
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The Downside Of Making Extra Principal Payments
While making extra principal payments sounds great, there definitely are some downsides.
- You lose liquidity Funds tied up in your home arent liquid. You would have to refinance in order to get access to the funds. This could take between four and six weeks to get done. If you need the money fast, this could be an issue.
- You may lose money Depending on the state of the economy and the market, there may be better places to invest your money, such as stocks, bonds, or money market funds. This is called opportunity cost, which may affect your financial position when you retire.
Mistake #: Not Considering All Of Your Options
It can be very tempting if you come into some extra money to put that toward paying your mortgage off ahead of time. However, getting out of debt a little bit earlier may not be the most remunerative choice to make. To illustrate this, lets look at an example.
Lets say youre considering making a one-time payment of $20,000 toward your mortgage principal. Your original loan amount was $200,000, youre 20 years into a 30-year term, and your interest rate is 4%. Paying down $20,000 of the principal in one go could save you roughly $8,300 in interest and allow you to pay it off completely 2.5 years sooner.
That sounds great, but consider an alternative. If you invested that money in an index fund that represents the S& P 500, which averages a rate of return on 9.8%, you could earn $30,900 in interest over those same 10 years. Even a more conservative projection of your rate of return, say 4%, would net you $12,500 in interest.
Everyones financial situation is unique, and its very possible that the notion of being out of debt is so important to you that its worth a less than optimal use of your money. The important thing is to consider all of your options before concluding that paying off your mortgage earlier is the best path for you.
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Do I Have To Pay Off The Whole Mortgage
No often you might just want to make a capital repayment that only partially pays off the mortgage. All the same arguments about being better off doing this still apply. Even if you have enough money to pay off your whole mortgage, you should still try to keep some aside as a rainy day fund. So in the example that you had a £100,000 mortgage and £100,000 savings, you may want to just pay off £75,000 of the mortgage and keep £25,000 savings.
What Is The Biggest Reason Not To Pay Off My Mortgage Early
In short: opportunity cost. The money in your savings account is yours to do what you like with, but once you have paid off the mortgage that is it. If you pay off your mortgage early, you cannot then use the money for anything else, which could be alternative investments , splurging on luxuries like a new car, or coping with costs such as mending your roof or paying school fees.
Once you have paid off the mortgage, it will be difficult to get the money back again, unless you go through the hassle and expense of taking out a new mortgage, which might be difficult since lenders have been tightening their conditions. If your household income has gone down, you simply might not be able to borrow as much. And, whereas once there was tax relief on mortgage interest, this has not been the case for some time.
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How To Make Extra Principal Payments
Now you may wonder how you can make extra principal payments. For example, what if you dont have an extra $100 or more per month to put towards your mortgage? Luckily, there are a few ways you can make this happen.
- Pay extra each month The easiest method is to come up with a set amount of extra funds youll put towards your mortgage each month. There isnt a set amount. While $100 each month would be nice, even just $25 each month can knock a few years off your loan.
- Make one extra payment each year If you have a certain time of year that you make more money , you may pay one extra mortgage payment each year. This has a similar effect of paying extra money each month you just pay it in one lump sum.
- Pay 1/12th of the mortgage payment in addition to your mortgage payment If you take your principal and interest payment and divide it equally into 12 payments throughout the year, youll make one extra payment each year.
The Pros And Cons Of Going Interest
Most people with home loans will agree the goal is to pay them off as quickly as possible. But for those considering interest-only mortgages, that might not be your top priority.
Interest only home loans are designed with very specific borrowers in mind. Its a type of home loan where you pay just the interest for a set period.
There are several reasons why you might consider an interest-only home loan perhaps youre temporarily down to one income due to a new baby or sickness, you need the spare cash for something else, or youre a property investor. While lower monthly repayments might seem like an attractive choice, its crucial to weigh up the pros and cons of this type of loan before you sign on the dotted line.
Features of interest-only mortgages
An interest-only mortgage is just that the mortgage repayments you make go towards paying just the interest for a set amount of time. Because your repayments arent reducing the principal of your loan, that essentially stays the same.
This type of loan is typically a maximum of five years, after which it reverts to a normal principal-and-interest mortgage.
Setting up an interest-only mortgage isnt for everyone. In fact, its not suitable for most people only a select few. Often borrowers will consider this type of loan because they want to pay less each month, but since this means they pay far more in the long run, it wont suit most home buyers.
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Conforming Vs Nonconforming Arms
Beyond the loan term, you will encounter conforming loans and nonconforming loans as you explore your ARM options.
Conforming loans are mortgages that meet specific guidelines that allow them to be sold to Fannie Mae and Freddie Mac. Lenders can sell mortgages that they originate to these government-sponsored entities for repackaging on the secondary mortgage market if they conform to their rules.
If a loan doesnt meet these specific guidelines, then it will fall into the nonconforming category. But beware of the potential pitfalls before jumping into a nonconforming loan! Although there are good reasons why borrowers may need a nonconforming mortgage, and most originators of these loans are reputable, many are not. If youre considering a nonconforming ARM, read the fine print about rate resets very carefully and make sure you understand how they work.
One corollary to this is that FHA and VA ARMs are considered nonconforming according to the rules of Fannie Mae and Freddie Mac, but they have the full backing of the U.S. government. With the might of the federal governments backing, you might be more comfortable choosing one of these loans if theyre available to you.
How Much Will I Be Able To Borrow
Lenders base affordability on your level of income and your level of outgoings. Some providers will cap what theyre willing to lend based on 4x your income, while others will stretch to 5x, and a minority 6x, under the right circumstances.
Different lenders also consider additional sources of income, such as bonuses or commission in different ways. Some lenders are able to consider 100% of bonus, while others may take 50% into consideration and some lenders may disregard bonus payments altogether.
Say your basic salary is £30,000, but you earn an annual bonus of £20,000. Heres what different lenders might be able to lend to you:
|Lender 1 50% bonus + 4x income||£20k x 50% = £10,000|
|£30k + £20k = £50,000||£50k x 5 = £250,000 max loan|
In this example, this difference between the amount the two lenders will lend is £90,000, not because your circumstances have changed but because of the different ways they calculate your affordability.
You can read our guide to mortgages based on bonuses and commission income for more information, but speaking with one of the expert brokers we work with will ensure you get the best possible outcome for the amount you want to borrow and the best available rates too.
Did you knowYou could access 25% more of the mortgage market with a specialist Interest-Only broker on your side Get Started with an OMA-Expert to unlock the entire market and increase your chance of mortgage approval.
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The Pros Of An Interest
Interest-only loans may make financial sense for some borrowers because:
- The initial monthly payments are usually lower: Since youre only making payments towards interest the first several years, your monthly payments are usually lower compared to some other loans.
- May help you afford a pricier home: You may be able to borrow a larger sum of money because of the lower interest-only payments during the introductory period.
- Can be paid off faster than a conventional loan: If youre making extra payments towards an interest-only loan, the lower principal can generate a lower payment each month. When it comes to a conventional loan, extra payments can reduce the principal, but the monthly payments remain the same.
- Possible increase to your cash flow: Lower monthly payments can leave you with a few extra dollars in your budget.
- Rates may be lower: This type of mortgage is usually structured as an adjustable-rate loan, which may result in lower rates than a fixed mortgage.
Am I Eligible For An Interest
The most important thing you need to demonstrate when switching from a repayment mortgage to an interest-only arrangement is a sound and reliable plan for paying off the whole loan at the end of the term.
Many lenders are happy to lend on an interest-only or part and part basis, but they will want to know that you have a practical repayment strategy in place.
Lenders have different criteria as to what they will accept as a repayment strategy. Some might look for regular repayments to be made into a savings or investment account, while others can consider other assets, such as buy-to-let investments. Some lenders can even accept the sale of the property at the end of the term if you plan to downsize or move into rented accommodation.
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The Cons Of An Interest
Choosing an interest-only loan could be a risk for borrowers. Some cons with this type of loan include:
- Youre not building equity in the home: Building equity is important if you want your home to increase in value. With an interest-only loan, you arent building equity on your home until you begin making payments towards the principal.
- You can lose existing equity gained from your payment: If the value of your home declines, this may cancel out any equity you had from your down payment. Losing equity can make it difficult to refinance.
- Low payments are temporary: Low monthly payments for a short period of time may sound appealing, but they dont last forever it doesnt eliminate the eventuality of paying back your full loan. Once the interest-only period ends, your payments will increase significantly.
- Interest rates can go up: Interest-only loans usually come with variable interest rates. If rates rise, so will the amount of interest you pay on your mortgage.
Can I Switch To An Interest Only Mortgage If I Have Credit Problems
The answer is often yes switching to an interest-only mortgage is possible, depending on what type of credit problems you have had and how recently you have had them.
While some providers might turn you away outright, specialist bad credit providers have the flexibility to take a broader view of your mortgage application.
In general, bad credit lenders will want to know what the issue is, how long ago it was, how much it was for and whether it has been repaid. Some lenders will also ask for an explanation about previous credit problems to help them to understand whether these were one-off events or are likely to happen again.
For more information on how to get a mortgage with bad credit, we cover each credit issue and how to get a mortgage approved extensively within our bad credit page.
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Example Of Mortgage Interest Over Time
To illustrate how amortization works, consider a traditional, fixed-rate mortgage for $100,000 at an annual interest rate of 2% and a time to maturity of 30 years.
The monthly mortgage payment would be fixed at $369.62.
The first payment would include an interest charge of $166.67 and a principal repayment of $202.95. The outstanding mortgage balance after this payment would be $99,797.05.
The next payment would be equal to the first, $369.62, but with a different proportion of interest to principal. The interest charge for the second payment would be $166.33, while $203.29 will go toward the principal.
This example applies to a basic, fixed-rate loan. If you have a variable- or adjustable-rate mortgage, it is also likely to apply a greater portion of your monthly payment to interest at the outset and a smaller portion as time goes on. However, your monthly payments will also adjust periodically, based on prevailing interest rates and the terms of your loan.
There is also a less common type of mortgage, called an interest-only mortgage, in which the entirety of your payment goes toward interest for a certain period of time, with none going toward principal.