When you look at your mortgage payment slip each month, you may notice that you have the option to make more than your required payment. Some people prefer to use this option to make one or more additional mortgage payments each year. It has its benefits, but you have a few considerations to take into account before you choose this strategy.
Benefits of making extra mortgage payments include paying less interest over the loan term and shortening the time it takes to pay off your mortgage.
Benefits of Additional Payments
You have two main benefits to consider when deciding if you want to pay an additional principal payment each year. For one, you pay less interest over the course of the loan. For example, say you make payments on an $85,000 30-year loan that charges 5.875 percent interest ($502.81 per month). The interest cost if you make payments as agreed is $96,010.56. If you make one extra payment of $400 at the end of each year toward principal, the total interest drops to $78,691.21.
Also making that additional principal payment cuts time off your loan – in this example about four years. Use the Bankrate mortgage calculator to do your own estimates.
However, at the same time that you're calculating these benefits, you should also consider whether it's more worthwhile to put that extra payment each year toward an investment or savings. Consult with a financial adviser.
Beware of Prepayment Penalties
Hold on for a moment – before you start making additional principal payments on your mortgage, you have to find out if your lender will charge a prepayment penalty. A prepayment penalty is a charge that penalizes you if you try to pay off the loan earlier than scheduled. Lenders put this clause into some agreements to ensure that they receive a certain profit from the loan.
If you pay off the loan early, you save interest, but the lender loses interest profit. If this is your situation, weigh the financial benefits of making an additional payment each year compared to the prepayment penalty the bank charges.
Suggestions for Making Extra Payments
You have a number of options for making that extra payment each year. You could save up a small amount each month and put it aside in a savings account, then withdraw the balance at the end of the year to make the extra principal payment. If you receive a bonus every year around the holidays, you can also use some of that money to make the additional payment.
Let Your Lender Know
If you do send an extra principal payment to your mortgage company, make sure you clarify that it's for extra principal. In some cases, the mortgage company could apply it to either your next month's payment or late fees due on your account. You can send the extra principal in a separate mailing, include a note specifying that it's for principal and write "extra principal payment" in the memo area of your check.