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How to Prepay Your Mortgage
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One of the downsides of listening to Sirius XM radio is that you start to hear the same commercials over and over and over again. It’s one of the reasons why I thought to do more research into stock loss companies. After listening to numerous ads from companies like 9 Year Mortgage (pay off your mortgage in 9 years!), I thought I’d do an analysis of all the various mortgage prepayment strategies.
There is only one way to pay off your mortgage faster – pay more money and pay more often. Outside of paying more and paying more often, there isn’t much else you can do besides refinance so your interest rate is lower. The only services that are legitimate are the ones that help you manage the payments and keep you on track, but those usually are more expensive than they are worth.
For our examples, we’ll use Bankrate’s mortgage calculator and it’s default values to help calculate the savings of these different strategies. The default values are:
- Mortgage – $165,000 for 30 years fixed at 7% interest
- Payoff Date – April 23, 2042
- Monthly Payment – $1097.75
- Total Interest – $230,189.68
Make an Extra Payment
One of the simplest, albeit least effective, ways to prepay your mortgage is to simply make an extra payment at the end of the year. In our case, since our loan starts in mid-April, we’ll add the extra $1097.75 payment every April. By making it every twelve months, you pay off your mortgage in April 2036 – exactly six years early. Your total interest paid is $175,989.85, a savings of $54,199.83. If you were to make the extra payment in December, rather than wait the twelve months, the payoff day changes to February 2036 and your total interest paid drops slightly to $174,455.09.
Pay Extra Principal Each Month
Instead of making a $1097.75 payment in principal at the end of the year, why not spread that out across the year? You can add $91.48 to each payment and pay off the mortgage by January 2036, a little more than six years early. More significantly, the total interest paid drops from $230,189.68 to $173,855.83 – a savings of $56,333.85.
Pay Every Two Weeks
A merge between the above two strategies is to pay every two weeks. With the two monthly half payments, you make 24 half-mortgage payments a year. There are, however, 52 weeks a year so this strategy has you paying 26 payments. It’s, effectively, an extra monthly payment spread out across the year and made more frequently than paying extra each month. According to this calculator by Bankrate, you would pay off the loan in December 2035 with total interest payments of $171,531.91, a savings of $58,657.77.
Recap
It’s not difficult to see that the more often you make payments, the more interest you will save. The deciding factor is whether the savings justifies the additional effort. Remember, these are savings across the entire loan term. Here’s how they all stack up in terms of savings:
- Doing Nothing – $0
- Extra Payment – $54,199.83
- Extra Principal – $56,333.85
- Every Two Weeks – $58,657.77
Making an extra payment or paying additional principal is likely going to be very easy with your lender. Setting up a system where you pay every two weeks will probably be trickier, though some lenders offer this (as do third parties). Let these savings differences be your guide in what makes sense for you.
Before You Prepay
Before you prepay anything, ask your lender what you need to do so they know that the extra funds should go towards principal. Many lenders will apply excess payments to the next payment, because it’s better for them, so find out what you need to write, say, or do in order to have the excess applied to your principal. If it doesn’t, then all this is for naught.
Also, it’s important to remember that making additional payments will not make future payments smaller. It will reduce the number of months remaining on your mortgage loan.
(Photo: wwworks)
{ 21 comments, please add your thoughts now! }
When we decided to purchase our first home, we also decided that we will be paying twice the monthly amortization to reduce the number of years that we need to pay for it. Moreover, it will also reduce the interest that we needed to pay for it.
keep in mind that the extra payment and the semi-monthly payments must be allowed by your servicer/bank. some banks force you to make next months payment in order to apply anything to interest. My bank wont allow me to make semi-monthly payments, or at least apply them. They’ll collect my money… but wont apply it until its due thus storing my money interest free.
I believe virtually all banks work this way – pay any extra money after the first of the month and it gets APPLIED the first of the next month.
However, with interest rates on savings accounts now a days – this is really nothing to worry about – IMO.
not sure what you mean by “…after the first of the month…”
If you mean, any second payment… then that is true with my bank and i can agree with your statement that generalizes most banks are like that.
however, if you mean, any additional money on top of your actual payment goes to the next month then your wrong on my bank and probably wrong altogether. i can make an additional payment and it will go directly to principle so long as it is included in my monthly mortgage payment. If i make two payments in one month, it will unfold just like you mentioned.
I believe this is what you meant but it’s not what you wrote.
Also, it’s important to remember that making additional payments will not make future payments smaller. It will reduce the number of months remaining on your mortgage loan.
Unless you do a recast.
Also should point out that making additional payments early in the mortgage has a much larger impact than making them later, since the % of the base payment going to principal is much smaller in the beginning.
We recently refinanced our mortgage which reduced our interest rate by 40%, lowered our monthly payment and gave us more money to redirect to paying off a vehicle loan that was higher interest rate.
We shopped with several lenders online and finally went with a local lender that gave us a great rate plus first rate customer service.
Forget extra payments, REFI to a 15 YR or 10 at 3.5% or lower depending on your score. Transitioning from a 30 YR @ 4.75% to 15 YR @ 3.5% on $400K will save you over $200K. Its a no brainer. Who wants to pay an extra $200K for borrowing money…
Also, make sure your review your AMORT table to determine at what point your interest is lower that your standard deduction. Either itemize more deductions to beat the standard or have another kid or better yet buy another house. On a 15 YR, year 7/8, the interest paid is nearly the same as the standard deduction for married couples.
Buy RE!
Best
This is great advice! Cheers!
spending money to “save” money? ahh yes… the american dream
thanks Jim, for the simplest presentation of an argument in favor of reducing interest long term on a mortgage. I would only add that another point to consider which argues in favor of accelerated payments is the fact that with savings interest rates so low, it behooves anyone to take a chunk of the money they have saved and plow it into their mortgage since mortgage interest rates nowadays, even on the best of terms, are 4 to 5 times higher that the best savings rates–you save more by paying down your mortgage than by “saving”.
You have helped to take much of the mystery out of the various ways you can pay off your mortgage sooner and save money. Thanks for making it so simple to understand..
Jim, do you know of a calculator where you can add X monthly amount to your mortgage that doesn’t start at the beginning of the mortgage term? The bankrate calculator assumes you make the extra monthly amounts from the beginning of your mortgage, but what if you started half way through your mortgage or some other month?
I’m afraid I don’t…
eric: Try this one…
http://www.dinkytown.net/java/MortgageLoan.html
It allows you to specify when you start making the extra payments.
Jim, thanks for the reply! Nickel, thanks for finding one. Appreciate it!
I believe you hit the nail on the head with “pay more money and pay more often.” Good practical tips!
As chimchim stated earlier, if you’re able to make the extra payments, you might as well refi and take advantage of the rate! No better time than now. I’m almost thru with my no cost refi for the second time in the past 12 months for a 7/1 ARM at 3.125% for my condo 🙂
We included extra money to our regular monthly payments for the last several years of our mortgage loan with a memo in each one to add that amount to the principal. The savings in interest was definitely more than the interest we would have earned in a savings account and well worth including the additional memo to be sure of where the extra money went.
After I read your post I tried the Biweekly calculator at Bankrate,but was disappointed it doesn’t allow for extra payments.
I searched for another,and found an awesome one-it allows you to input pretty much everything,shows monthly vs biweekly interest etc.,creates a payment schedule…
Bi-Weekly Mortgage Calculator With Payment Options
http://www.benningtonhomes.com/PaymentOptions.html
Jim,
Did you check out the product that is being advertised? Are they claiming anything different?