How to Prepaying Your Mortgage

How to Prepaying Your Mortgage
What Homeowners Need to Know about Prepaying Your Mortgage

Prepaying your mortgage - which simply means that you pay all or part of the money owed on your mortgage before it's officially due -- offers an alluring proposition: By paying what you owe early, you can cut down the amount of interest you owe to the lender, which can save you thousands of dollars in the long term. But before you prepay your mortgage, it's important to understand these things:

How do most people prepay their mortgage?

People prepay their mortgages in a variety of ways, but one of the more popular methods is to pay a little extra on your loan each month, which over the life of the loan could save you thousands or even tens of thousands of dollars. Let's say you owe $100,000 on your 30-year loan at a 4 percent interest rate. If you paid the loan as scheduled, you'd end up paying the bank roughly $71,000 in interest. If, however, you added just $75 a month to your monthly payments, you would save more than $17,000 in interest and repay the loan more than 5 years faster. Some people also make bi-weekly mortgage payments, which effectively leads to you making 13 months of mortgage payments in a year, compared with the traditional 12. Before you decide which method to choose, do the math to see which is most financially effective and which you think you can actually stick to.

Are there restrictions on prepaying your mortgage?

While the terms of some mortgages allow you to prepay the loan without restrictions, other mortgages have stricter terms. More specifically, some lenders require borrowers to pay a penalty for prepaying the mortgage -- sometimes the amount of this penalty is based on a sliding scale depending on how long you've held the mortgage (for example, if you prepay after one year, you might have to pay a fee worth 4 percent of the total loan amount, compared to a penalty of 3 percent after two years) and sometimes a one-time fixed amount. Often, lenders demand a prepayment penalty if you prepay the mortgage before a certain amount of time, usually five years, to deter borrowers from quickly refinancing their loans, which would drastically cut into the lenders' profits. There are other variables to these penalties, including the fact that some lenders don't consider a sale of a home a “prepayment” and others allow you to pay up to a certain amount before the penalty kicks in.

The terms of the prepayment penalty vary significantly, so it's important to read through your mortgage paperwork. Typically you will see terms such as “prepayment penalty disclosure” or “prepayment disclosure,” after which the specifics of the prepayment penalty are usually listed.

Should you refinance, prepay or both?

There isn't a right or wrong answer to this question. First, you have to think about your goals. If your goal is to pay less money to the lender in the long run, both refinancing (by lowering your interest rate or shortening the term of the loan) and prepaying your mortgage (by lowering the total amount you owe the lender and shortening the term of the loan) can do this. If your primary goal is to lower your monthly payments, refinancing is probably the way to go; if you primary goal is to pay off your mortgage ASAP, prepayment may be the way to go.

However, it might be better to think about refinancing and prepayment separately. If it makes financial sense to refinance, go ahead and do that. Then make prepayments on the new, lower-interest loan; just be sure to get a loan with no or reasonable prepayment restrictions. Remember, it's important to consider your entire debt load when thinking about prepayment. If you have high-interest debt such as credit card debt, you're probably better off paying down that debt before you pay down your lower-interest loan.

7 Steps to Prepay Your Mortgage

Step 1: 
Evaluate whether prepaying is right for you. In the short term think of prepaying your loan as investing, but investing in a large, illiquid asset. That is, you must sell the house to get the money out again. If you have a low interest rate and you are making good returns on investments, it may not be worthwhile. If other debts are costing you more or if you have little or no savings, focus on those priorities first. The long term prepayment is by far the best thing to do. When the mortgage is paid off 100% of the money you would have paid can now go for investments.

Step 2: 
Find out the interest rate on your mortgage and the remaining balance. If it isn't on your statement, call your bank or whoever is carrying your mortgage to find out.

Step 3: 
Use a mortgage calculator (there are many available online or make your own) to find out how much you are paying in interest over the life of the loan.
Look for a calculator that gives you an amortization schedule, preferably with a graph of interest and principal paid over time.
Look for a calculator that will let you run scenarios and see what happens if you prepay at various rates.

Step 4: 
Decide how much you will prepay. There is no one right answer to this question. Here are some possibilities:
  • Prepay a certain percentage of your income. One or even half a percent might be small enough to be painless and still make a big dent.
  • Prepay a certain amount each month. Choose a nice, round number that seems right to you.
  • Pay a monthly amount that you were paying before on a different loan. If you just paid off a car loan or credit card, put that amount towards prepaying your mortgage instead.
  • Continue to pay the monthly amount that your mortgage cost before refinancing, even though the new monthly payment is less.
  • Pay the amount of a raise you have just received. The advantage of choices like these is that they keep the rest of your finances the same as they were before. You will not notice that new, "extra" money is going elsewhere.
  • Make one extra payment per year. Divide your monthly payment by 12 and pay that much extra each month. Don't wait until the end of the year or rely on your memory.
Step 5: 
Phone your bank or mortgage company and verify that any extra payment will get applied immediately toward paying down the principal. They may ask that you enclose a form letter or add a memo to each check to this effect. Prepaying a mortgage is still uncommon enough that some companies don't seem to know what to do about it.
  • Check that your first couple of payments went to the right place. Read your statement after the first extra payment and verify that the payments are being correctly applied against your principal.
Step 6: 
Automate your payment. The mortgage company may be able to do this for you, or if you have online bill pay with your bank, you can make either a separate payment or an increased payment automatically that way. While you could theoretically make the extra payment manually each month, it is probably easiest to automate it once and let the bank remember the new schedule for you.
Make sure to include your account information and prepayment instructions with your payment.
  • It may help things get processed correctly if you send a separate check or payment for the part you are prepaying. If you are using an online bill pay service, simply set up two payments at the same time each month.
Step 7: 
Look into a biweekly payment plan. Many people prefer this option because it is simple and lines up with their biweekly paycheck schedule. With a biweekly payment plan, you simply pay half the monthly amount every two weeks. This has the effect of paying one extra payment per year. Set up a biweekly payment plan through your mortgage company or through an independent service. A phone call or two should be enough to set up the payments.
  • With this choice, you must generally set up a plan specifically.
  • Make sure, if you are paying biweekly, that the mortgage company knows what to do with the extra payments.
  • Ask whatever institution sets up your biweekly plan whether the payments get applied immediately, and don't sign up if the answer is no. Some companies, especially third party services, withdraw the funds biweekly and only make the additional payment at the end of the month or year, earning interest on your money in the meantime.
  • Expect a setup fee of a few hundred dollars, and ask what the fees will be before you sign up. Although this sounds like a lot of money, the money you save over the life of the loan will be much more. If you still don't like the fee, set up an automatic transfer yourself.
  • You do not necessarily need to pay someone else to set up your payments for you once you have calculated what they need to be. It's free to do it yourself, and you will save more money (the fee associated with this plan).