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Money problems? Struggling with credit card debt? What you need to know about bankruptcy? Trouble repaying student loans?
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Gary,
I once heard a financial planner say you can reduce the numbers of years it takes to pay your house off. She said that if you make one extra house payment a year, you could reduce a 30-year mortgage to 22 years and a 15-year mortgage to 12 years. Can you please explain how this works?
RM in FL
What RM heard was generally correct. But lower interest rates have changed it a bit. Let's explore mortgage prepayments and how to make them work.
First, recognize that there's a big advantage to getting your mortgage paid off. It frees up a sizeable amount each month that can be used for other things.
Yes, it's a big long-term goal. But, unlike some other distant goals, you don't need to get to the finish line to benefit from your efforts. Even if you only prepay principal one time, it will make every regular payment after that more efficient.Mortgage prepayment penalties are common on "sub-prime" loans. source: Wall St. Journal
RM will want to get familiar with something called an "amortization table." It shows month-by-month how much of each payment goes to paying interest, how much to reducing principal and what the remaining balance of the mortgage is.
The key factor in paying off any mortgage is how much of the monthly payment goes to reducing the principal amount owed. For instance, RM would be in the 18th year of the 6%, 30-year mortgage before half of his payment went to principal repayment.
A 30-year mortgage for $150,000 at 6% interest will earn the mortgage company $173,757 in interest. The monthly payment will be $899.33. But in the first month, only $149.33 of principal will be repaid.
What happens if RM does make an extra payment each year? Fortunately a mortgage calculator does the math for us. I'm partial to one at Bankrate.com http://www.bankrate.com/calculators.aspx
One extra payment per year would reduce the length of the loan to 24 years and 9 months. It also would reduce the amount of interest paid over the life of the loan to $138,295.
Back to RM's question. Why doesn't the annual prepayment reduce the 30-year mortgage to 22 years? It's because of the low interest rates. If the rate were 9.2% then one extra payment a year would reduce the term to 22 years.
Same deal for a 15-year mortgage. At a rate of 5.25%, the mortgage would require a monthly payment of $1,205.82. One extra payment per year would reduce the term to 13 years and 5 months.
OK, so we agree that prepaying your mortgage is a good thing. But for most families making an extra mortgage payment doesn't seem like a reasonable goal. Yet, it isn't impossible. One way to be successful is to break it down into 12 monthly parts.
By adding $74.95 ($899.33 divided by 12) to each monthly payment, RM would be doing the same thing as making one extra payment per year. The length of the mortgage drops to 24 years and 7 months.
A simple change in lunch or entertainment habits could provide that much saving. Just think of it as trying to avoid spending $2.50 per day. Or, if reducing spending isn't possible, perhaps RM could use his next salary increase for mortgage prepayment.
Refinancing your current mortgage could also be a solution. Instead of using the extra money for other things, continue making the same monthly payment that you made before the refinancing.
Suppose that RM had a $150,000 8% mortgage and refinanced to 6%. The difference in payments is $201.32. But if RM continued to pay the $1,100 that they had been paying before the refinancing, he'd have the mortgage paid off in 19 years and two months.
Before you make any prepayments, you need to check your mortgage for two things. First, verify that prepayments are allowed. Second, make sure that any extra amounts that you send in are applied to reducing principal. In fact, you'll probably need to indicate on your check or the payment stub how much extra is meant for principal reduction.
It's a good idea to make sure that the bank is applying any prepayments correctly. More than one person has had a prepayment applied as an "early payment" for the next payment due. That will not do you any good.
There are services that charge to check your balance. But it's really not that difficult if you have a copy of the amortization table. Based on the previous month's principal owed, the table will tell you how much of your regular payment would go to reducing the principal. With that and the amount of your prepayment, you'll be able to calculate the new balance. Just verify that amount with the mortgage company by phone or the web.
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Gary Foreman is a former financial planner and purchasing manager who currently edits The Dollar Stretcher.com website and newsletters. You can also follow Gary on Twitter or on his blog.
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