This post was contributed by Jennifer Riner of Zillow.com
Freeing yourself from the confines of a mortgage isn’t just emotionally rewarding – it’s financially savvy, too. Homeowners sometimes assume when they sign up for their 15- or 30-year mortgage terms, they’re indebted to the mortgage lender for that specified length of time, and they owe the predetermined amount of interest they signed up for initially.
However, prepaying mortgages can both shorten the loan term and lessen total interest owed to the lender, allowing borrowers to save money in the long run. If you’re considering prepaying your mortgage to save money over time, consider the following elements of prepayment.
How Does Prepayment Work?
Monthly mortgage payments encompass four expenses: principal, interest, insurance and taxes. Principal and interest are often lumped together and referred to as P&I, but when considering prepayment, these two expenditures are separated. Prepayment applies solely to the principal portion of the monthly mortgage, since homeowners avoid paying interest when overpaying their predetermined mortgage rate.
Assume you owe $100,000 on a 30-year loan at a 4 percent interest rate. By paying your mortgage as scheduled, you’d end up paying $71,000 in interest over the course of 30 years. But, by paying an extra $75 per month, you can save $17,000 in interest and shorten your loan by 5 years. This is considered a lump sum prepayment, and is also one of the more common methods borrowers use to save on interest costs over time.
The alternative to lump sum prepayment is bi-weekly mortgage payments, which allows borrowers to make an extra mortgage payment each year, totaling 13 payments annually compared to the typical 12. For example, with a 30-year fixed mortgage of $200,00 at 4.5 percent, a biweekly payment plan would save $27,240 and four years and four months in loan length.
While prepaying lessens the total amount of time you’re locked into your mortgage and alleviates your total interest fees, some homeowners prefer to pay their fixed mortgages because the interest is tax deductible in the first few years of homeownership, when interest is inherently higher. If you’re still on the fence, it might be beneficial to first stick with your designated mortgage payment plan, and then consider prepaying after new homeownership tax savings disappear.
Biweekly prepayment programs require activation costs of $150 to $200, and biweekly charges afterward, amounting to $130 to $520 annually. While seemingly minor, these extra costs should be considered when weighing the monetary benefits of mortgage prepayment.
Keep in mind, current mortgage rates are lower than ever. If you have other debts to resolve, like high interest credit cards or student loans, it’s best to pay those off first before you start allocating extra funds toward your monthly mortgage payment. Further, if your property is depreciating in value, refinancing to avoid losing money might be the better option. Owners of underwater properties may consider short-sales instead of prepayments to eliminate negative equity, rather than investing more money toward a prospective loss.