Build Up A Rainy Day Fund
Save for an emergency. We recommend setting aside three to six months’ worth of living expenses in savings in case you lose your job or incur unexpected costs. Without those financial reserves in place, you could put your mortgage in jeopardy, which includes the extra money you worked so hard to put toward it if youre making extra mortgage payments
Case Study: Prepayment In Action
Let’s take a look at a hypothetical example. Say Joan is 10 years into a 30-year mortgage with an interest rate of 4%, an outstanding balance close to $275,000, and a monthly payment of about $1,300. She is approaching retirement and trying to decide if she should use her savings to pay off the mortgage before she stops working.
Let’s say Joan is a conservative investorshe holds about 20% of her portfolio in stocks, about 50% in bonds, and 30% in cash. If she prepays her mortgage, our estimate indicates she will end up improving her financial condition by reducing the risk of running out of money in retirement by about 5%, and improving her median final balance by about 13%.2
But what if she was a more aggressive investor and held 70% of her portfolio in stocks and 25% in bonds and 5% in cash. According to our estimates, if Joan decides to prepay, she would still reduce her risk of running out of money. But in terms of wealth, the outcome would likely change: Instead of increasing her final balance, prepaying the mortgage would actually hurt her wealth. Because her investments would have grown more than savings from repayment, Joan would see her median final balance decrease by about 5%.
Potential Benefits Of Making Additional Principal Payments:
1. Save on interest
Since your interest is calculated on your remaining loan balance, paying additional principal payments early in the loan may result in a significant reduction in the total amount of interest over the life of your loan. Talk with your lender to determine your projected savings based on the size of your loan, your interest rate and scheduled payment dates. You can find online mortgage calculators to get a rough estimate. As an example, if you make an extra payment each year on your $250,000, 30-year mortgage at a rate of 3.4%, you will save over $20,000 in interest over the life of the loan.
2. Shorten the length of your mortgage
Sending additional principal payments will shorten the life of your mortgage and build equity faster. In the example above, one extra payment per year would shorten the length of your mortgage by nearly four years, assuming you make all your payments on time.
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Make Extra House Payments
Lets say you have a $220,000, 30-year mortgage with a 4% interest rate. Our mortgage payoff calculator can show you how making an extra house payment every quarter will get your mortgage paid off 11 years early, and save you more than $65,000 in interestcha-ching!
But before you start making extra payments, lets go over some ground rules:
- Check with your mortgage company first. Some companies only accept extra payments at specific times or may charge prepayment penalties.
- Include a note on your extra payment that you want it applied to the principal balancenot to the following months payment.
- Dont shell out your hard-earned cash for a fancy-schmancy mortgage accelerator program. You can accomplish the same goal all by yourself.
What Does Paying Your Mortgage Biweekly Do?
Some mortgage lenders allow you to sign up for biweekly mortgage payments. This means you can make half of your mortgage payment every two weeks. That results in 26 half-payments, which equals 13 full monthly payments each year. Based on our example above, that extra payment can knock four years off the 30-year mortgage and save you over $25,000 in interest.
Are Biweekly Mortgage Payments a Good Idea?
Making 1 Extra Mortgage Payment A Year: What Is The Impact
Are you thinking about making 1 extra mortgage payment a year? Did you hear that it cuts a bazillion years off the term of your mortgage? Is that actually true? And should you start making these extra payments?
These are great questions! And theres actually another good one that you may be asking What if Im already halfway into my mortgage payments? Is it still worth it for me make these extra payments?
Yup, well answer this too. Lets hit it!
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Four Alternatives To Paying Extra Mortgage Principal
Before you begin making extra principal payments on your mortgage, its best to consider your overall financial goals. Consider how long you plan on living in the home. Assess any money that you can foresee needing in the future . And determine any current debts you are still paying on.
Assessing your current financial position and your future goals will help identify the ideal use for additional funds or maybe even prove that paying more on your mortgage is advantageous.
So, conversely, what are the alternatives , and what could the benefits be?
Advantages Of Biweekly Mortgage Payments
Here are a few reasons you may enjoy making biweekly mortgage payments.
- Its typically set-it-and-forget it
- Each payment is only half of a single monthly payment
- Its an easy way to automatically pay off your mortgage early
Biweekly payments can be a great option if you dont have much extra money leftover after paying the bills each pay period and you still want to repay your mortgage early.
Too many people think the only way to make extra mortgage payments is to make your monthly payment and pay a large additional amount every single month. But thats not true.
Even though you are still spending the same amount most months, the smaller biweekly payments can help you score quick mental victories like in the debt snowball method. And, smaller payments that better align with your paydays can also make it easier to plan how you will wisely spend your paycheck.
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When Mortgage Payments Start
The first mortgage payment is due one full month after the last day of the month in which the home purchase closed. Unlike rent, due on the first day of the month for that month, mortgage payments are paid in arrears, on the first day of the month but for the previous month.
Say a closing occurs on January 25. The closing costs will include the accrued interest until the end of January. The first full mortgage payment, which is for the month of February, is then due March 1.
As an example, lets assume you take an initial mortgage of $240,000, on a $300,000 purchase with a 20% down payment. Your monthly payment works out to $1,077.71 under a 30-year fixed-rate mortgage with a 3.5% interest rate. This calculation only includes principal and interest but does not include property taxes and insurance.
Your daily interest is $23.01. This is calculated by first multiplying the $240,000 loan by the 3.5% interest rate, then dividing by 365. If the mortgage closes on January 25, you owe $161.10 for the seven days of accrued interest for the remainder of the month. The next monthly payment, which is the full monthly payment of $1,077.71, is due on March 1 and covers the February mortgage payment.
Choose An Accelerated Option For Your Mortgage Payments
An accelerated payment option lets you make weekly or biweekly payments. With this option, youre putting more money toward your mortgage than with a monthly payment.
Accelerated payments can save you money on interest charges. By accelerating your payments, you make the equivalent of one extra monthly payment per year.
Increase Your Cash Flow
Since your mortgage is a major monthly expense, paying it off will provide you with a considerable amount of money that you can put to use. With the increase in cash flow, you can grow your savings, make improvements on your home, travel to new parts of the world or invest in the stock market. Paying off your mortgage early affords you the freedom to do what you wish with your money.
Con : Your Payment Isnt Applied As You Pay
Even though the payment is withdrawn from your bank account twice a month, it isnt applied to your mortgage that way. Your mortgage servicer holds the payment and applies it once a full monthly payment is received. The biweekly payment just forces an extra payment at the end of each year. If youd rather save and contribute that extra payment yourself, you dont have to change to a biweekly plan. Youll just have to check your mortgage agreements to ensure you wont be penalized for paying the loan off early.
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How Can Making Extra Payments Help
When you make an extra payment or a payment that’s larger than the required payment, you can designate that the extra funds be applied to principal. Because interest is calculated against the principal balance, paying down the principal in less time on a fixed-rate loan reduces the interest youll pay. Even small additional principal payments can help.
Here are a few example scenarios with some estimated results for additional payments. Lets say you have a 30-year fixed-rate loan for $200,000, with an interest rate of 4%. If you make your regular payments, your monthly mortgage principal and interest payment will be $955 for the life of the loan, for a total of $343,739 . If you pay $100 extra each month towards principal, you can cut your loan term by more than 4.5 years and reduce the interest paid by more than $26,500. 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 loan in less time is to make half-monthly payments every 2 weeks, instead of 1 full monthly payment. When you split your payments like this, youre making the equivalent of 1 extra monthly payment a year . This extra payment may be applied directly to your principal balance. Be sure to first check with your lender if this is an option for your loan.
The Benefits Of Paying Sooner Rather Than Later
Mortgage amortization, which is the process used to determine how much of your payment goes toward principal and how much goes toward interest, is a complicated subject. To put it simply, mortgage payments tend to be interest-heavy at the beginning of your loan . Since less of your scheduled payment is going to principal, extra principal payments have a larger impact, and deliver greater savings, when theyre made early in your mortgage. Adding even a little extra to your payments can have a significant impact on the amount of interest that youll ultimately pay, the total cost of your loan, and the length of time it will take you to pay it off.
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How To Make A Principal
Consider budgeting some extra money on a monthly basis to make an additional principal payment toward your principal balance. You have several ways you can go about this.
One is to make more frequent payments or wait to gather them into one large annual payment. Alternatively, you could pay a greater sum on each monthly installment which can help you avoid possible fees. Lastly, you can wait until you have an influx of money, such as after receiving a gift or an inheritance.
Make sure to double-check with your lender that the extra payments are credited directly toward your principal.
Benefit Of Making 1 Extra Mortgage Payment Per Year
If you make 1 extra mortgage payment a year, you WILL save money on your overall mortgage, and you WILL pay it off sooner. All that is true.
But the big question is, What is the real impact? Is it really worth the added effort and dollars?
Lets say you currently have
- A $300,000 mortgage
- an interest rate of 3.2%
- a fixed-rate 30 year mortgage
If you start making 1 extra mortgage payment a year from the very beginning of a 30-year fixed mortgage, you will:
- only have to pay your mortgage for 26 years
- and youll save $22,000 in payments!
Con : There May Be A Set
Some financial institutions will charge you a set-up fee to participate in a biweekly mortgage payment plan. Additionally, there may be an associated fee for each transaction . Some banks do offer this service for free, but its best to check with the financial institution currently servicing your mortgage.
What Are The Current Terms Of Your Mortgage
Before you attempt to pay off your mortgage early, its important to gain a concrete sense of the conditions you established with your mortgage lender. Knowing the length of your loan term will help you determine how long it will take you to pay off your mortgage if you make the minimum payment each month. Being aware of your interest rate will tell you how much interest youre currently paying on the remaining balance of your mortgage principal.
You should also see whether you agreed to a fixed- or adjustable–rate mortgage . If you have an ARM loan, youll want to know how market rates have changed since you first obtained your mortgage. If market rates are higher, paying off your mortgage early may be the right move.
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Understanding How Mortgage Payments Work
By Romana King on January 25, 2016
Extra mortgage payments reduce your debt, but not on a month-to-month basis
Q: I pay my mortgage monthly. Six months ago I increased these payments by an extra $400. Despite this extra money, the interest amount is still roughly the same on the mortgage. Is that normal? Shouldnt the interest portion be reduced since Im making extra payments?
Mortgage math confusion, Kelowna, B.C.
Answer No. 1: The general misconception is that the more principal you pay off, the smaller the interest portion on your monthly mortgage payment. The problem is its not a $1 for $1 ratio. To appreciate how this works, lets assume you take out a $500,000 mortgage at 2.49%, amortized over 25 years. To carry this mortgage, you would be required to pay $2,237 per month. Over the five year term of your mortgage, youll pay $76,896 towards the principal and another $57,345 in interest payments. Now, if you had started your extra payments in the first month of your five year term, your monthly payments would still be $2237, but you wouldve paid $102,417 against your principal .
Answer No. 2: Your mortgage payment is calculated on the outstanding balance of your mortgage so extra payments you make wont be so noticeable on a month to month basis. Thats because the interest portion of your payment makes up a much larger percentage of your total payment at the beginning of your mortgage terms then towards the end .
Year Vs 30 Year Loans
If a borrower makes an extra annual payment, the savings on interest can be quite substantial. On a 30-year mortgage with the original principal total of $250,000 and an interest rate of 6.5 percent, the monthly payment is $1,580, including both principal and interest. By making the scheduled payments over the life of the loan, the total amount paid in interest will be $319,000. However, if the homeowner pays one additional monthly payment per year, the total interest paid declines to $249,000, a difference of $70,000. This payment strategy shortens the loan from 30 years to just over 24 years.
An alternative to making one extra monthly payment per year is to make a higher monthly payment. For example, on a 15-year loan of $300,000 at 5 percent interest, adding $200 to each monthly payment reduces the interest costs substantially. If the monthly payment is $2,372, making a payment of $2,572 saves $15,376 in interest over the life of the loan. The loan is paid in full in 13.4 years instead of 15 years.
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What To Consider Before Prepaying Your Mortgage
Prepaying your mortgage is a great goal to work toward, but before you do, make sure youve met these financial milestones first:
Once those bases are covered, prepaying a mortgage comes down to discipline and comfort level. Do you want to be completely debt-free, or would you prefer your money working harder for you in other ways? Ideally, you want to pay off your mortgage before retirement so you dont have those monthly payments to worry about if your income becomes more limited.
Before You Do Anything Check Your Mortgage Terms For Penalties Or Special Instructions
Some mortgages come with prepayment penalties. What that basically means is that if you try to make an extra annual payment, increase your monthly payments, or make a lump sum payment, you may have to pay a fee for paying your mortgage off faster.
Similarly, other mortgages allow prepayments, but they only allow them at specific times, such as the anniversary of the mortgage. The best thing to do is call your lender to ask how you can go about paying more aggressively without paying penalties.
Lastly, when you talk to your lender, ask if there are any specific instructions that you have to give along with your additional payments. Some lenders require that you explicitly state or write a note explaining that you want the payment applied to the principal.
Otherwise, your payment could be applied improperly, making your effort for naught. For example, say you sent an additional end-of-year payment. Some lenders might, without the note, simply apply the additional payment to the following month instead of doubling up.
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