Paying off your mortgage early is not always the best financial move to make, cautions Liz Pulliam Weston of MSN Money: “Most people still have better things to do with their money, even in this environment, than to pay down a low-rate debt that's often tax-deductible to boot.” If your mortgage rate is low and you are carrying other high-rate debt, like credit cards or student loans, considering paying those off before you work to reduce your mortgage.
Mortgages, or loans used to purchase real estate, have set repayment schedules calculated through a process known as amortization. Although the actual calculation is somewhat complicated, the concept is very simple. A portion of each scheduled payment that you make is applied towards the original loan amount thereby reducing the principal balance, and the rest goes towards the interest that has accrued on the loan. Before the next payment comes due, the lender recalculates the loan based on the new loan balance. Because of these scheduled recalculations, you not only reduce the principal balance each time you make extra payments, you also reduce the amount of interest you pay over the life of the loan.
Because each month has an average of 4.3 weeks in it, bi-weekly mortgage payments result in 26 half-payments made each year, the equivalent of 13 full payments or one additional monthly payment per year. If you took out a $250,000 fixed-rate mortgage at 6.5 percent interest over 10 years, you would pay over $90,000 in interest over the life of the loan. If you worked out a bi-weekly repayment schedule with the lender, you would pay off the loan during year nine and save over $11,000 in interest. The Washington Post cautions that this type of repayment plan only helps if you have entered into a formal agreement with the lender to make bi-weekly payments. If not, the lender would credit the payment when it is due, not when you made it, and you would not benefit from a shorter mortgage term or reduced interest.
Any time you make an additional payment towards the principal on your mortgage, you shorten the length of the loan and reduce the total amount of interest. Doubling the amount of each scheduled payment that goes towards principal -- whether you are on a schedule of monthly or bi-weekly payments -- can reduce the life of your loan by almost 50 percent. Some people elect to make one additional payment per year. If you have a $250,000 fixed-rate mortgage over 10 years at 6.5 percent, making one additional payment of $2,383.70 per year or paying 1/12th of an additional payment, or $236.56, each month will shave one year off the life of the loan.
Before you start to pay your mortgage down, consult your lender to be sure your mortgage does not contain any prepayment penalty clauses. If it does, your lender can charge substantial fees for any reduction in the mortgage term, whether from refinancing, selling the home or making additional payments, according to Freddie Mac.
- The Mortgage Professor: Mortgage Amortization:-How Does it Work?
- "The Washington Post"; Add Up the Benefits Before Making Extra Payments; Jack Guttentag; December, 2007
- The Mortgage Professor: Mortgage Prepayment by Doubling Principal
- MSN Money: Don't Rush to Pay Off that Mortgage
- Freddie Mac: Prepayment Penalty Mortgages (PDF)
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