What is Prepaying Mortgage?

When you take out a mortgage, you’re committing to repay it over many years or even decades. However, that doesn’t mean you’re locked into that timeline. Here’s a guide to prepaying your mortgage, including the benefits and drawbacks, and an overview of potential savings.

How does prepaying your mortgage work?

Prepaying a mortgage means paying off your loan ahead of schedule. Typically, your monthly mortgage payment includes principal, interest, taxes, and insurance (PITI).

When you make extra payments, you’re contributing more than the regular monthly amount. These additional funds are applied directly to the loan principal rather than the interest, helping you reduce the overall loan balance faster and save money on interest.

Example: How much you can save with extra mortgage payments

Imagine you take out a $400,000 mortgage with a 6.8% interest rate. Your monthly principal and interest payment would be $2,608. Here’s how making extra payments could impact your mortgage:

What is a prepayment penalty?

A prepayment penalty is a fee that lenders may charge if you pay off your mortgage early, usually calculated as a percentage of the loan principal. While most borrowers don’t face this penalty, it’s important to check your closing disclosure before making extra payments to ensure that no prepayment penalties apply to your loan.

How to prepay a mortgage

Here are four main strategies for making extra payments on your mortgage:

• One Extra Payment Annually
• Biweekly Payments
• Additional Payments Anytime
• Recasting Your Mortgage

Make sure to instruct your servicer to apply any extra payments directly to the loan principal. Without this specification, the extra money may be used to cover your next mortgage payment, including both principal and interest, which won’t help you pay off your loan faster or save as much on interest.

1. One extra payment

Make an additional full monthly payment once a year. For instance, if your regular payment is $2,608, you would add an extra $2,608 payment each January.

2. Biweekly payments

Divide your monthly payment in half and pay that amount every two weeks. This results in 26 half-payments each year, which totals 13 full payments. Essentially, you’re making one extra payment annually.

3. Additional payments

Contribute extra funds toward your loan principal whenever you can, whether it’s from a windfall, such as a bonus or inheritance, or by adjusting your monthly budget to allocate more toward your mortgage.

4. Recast your mortgage

If you have a significant lump sum available, consider recasting your mortgage. This involves paying the lump sum along with a fee to your lender, who then recalculates your loan’s payment schedule. You’ll maintain the same number of payments and years to repay, but with a reduced balance and the benefit of retaining your current mortgage rate. Note that not all lenders offer this option, so check if it’s available for your loan.

Should I pay extra on my mortgage?

Pros

• Save Significant Money on Interest: Reducing the total interest you pay over the life of the loan.
• Pay Off Your Mortgage Sooner: Achieve full ownership of your home more quickly.
• Build Equity Faster: Increase your home’s equity at a quicker rate.
• Reduce Debt-to-Income Ratio: Improve your chances of qualifying for other loans.
• Eliminate Private Mortgage Insurance (PMI) Faster: If applicable, you can remove PMI payments sooner.

Cons

• Less Money for Savings and Investments: Limits funds available for other financial goals.
• Ties Up Funds in Your Home: Reduces liquidity as money is invested in your property.
• Smaller Mortgage Interest Deduction: Potentially decreases your tax deduction for mortgage interest.
• Possible Prepayment Penalty: Some mortgages have fees for paying off the loan early.

Before deciding to make extra payments on your mortgage, evaluate your overall financial situation with these questions:

• Is Your Budget Tight?: If your monthly budget is stretched thin after essential expenses, you might not want to allocate additional funds to your mortgage.
• Is Your Income Variable?: If your income fluctuates, it may be wiser to save extra funds for times when you have less income.
• How Long Do You Plan to Stay in Your Home?: If you’re close to paying off your mortgage or plan to move soon, consider maintaining your current payment schedule.
• Do You Have an Emergency Savings Fund?: Prioritize building a safety net with three to six months’ worth of expenses before focusing on extra mortgage payments.
• Are You Saving Enough for Retirement?: Use a retirement calculator to ensure you’re on track with your retirement savings.
• Do You Have High-Interest Debt?: It may be more beneficial to pay off higher-interest credit card balances or loans before making extra mortgage payments.

If you find yourself answering “yes” to any of these questions, it might be better to wait until you are in a more secure financial position before making extra mortgage payments.

However, as Linda Bell, senior writer at Bankrate, advises, “If it fits into your budget, you want to get rid of the debt, and you’re in good shape with other savings or investing goals, make extra payments on your mortgage. Every additional dollar shaves time off your loan and saves you interest.”