Make extra payments or refinance?
Paying extra on your mortgage can make good financial sense.
It means a guaranteed return on investment, which isn’t the case for other investments like mutual funds or stocks.
If your current mortgage interest rate is five percent, you are guaranteed to “earn” five percent — by saving interest — on any amount of principal you pay off.
Most conventional, FHA, VA and USDA mortgages allow you to make extra payments, also known as prepayments, without any penalty.
Making extra mortgage payments is not the right strategy for everyone, though. Homeowners often refinance instead, into a 15- or even ten-year mortgage. This drastically cuts their interest rate and slices years off their mortgage.
To see which option might be best for you, use our Extra Payment Calculator
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How much could you save by making extra payments?
Prepaying is not to be confused with making a mortgage payment early simply because you’re going to be out of town or indisposed next month, says mortgage banker Todd Huettner, president of Huettner Capital in Denver.
“When you prepay, you send your lender additional money and they apply it to your loan balance. This can save a ton of money, especially on a 30-year loan where most of your regular monthly payments go toward paying down your interest during the first several years,” Huettner says.
The savings could be huge.
A 30-year fixed-rate mortgage at 4% and $200,000 borrowed would require about $140,000 in interest over the life of the loan.
But if you were to prepay just an additional $100 a month toward principal, you would save about $30,000 in interest, and pay off that loan five years quicker.
Here’s another prepayment perk: unlike the capital gains and dividends earned on other types of investments like stocks and bonds, the savings earned from prepayments are not taxable.
The prepayment process is relatively simple. “Take the time to write a separate check or send a separate electronic payment to your lender and explicitly state in the memo or on a separate note that this extra payment is to be applied toward the principal on your loan. Otherwise, the bank could possibly apply your extra payment to the next month’s interest,” says Jason van den Brand, CEO of San Francisco-based Lenda.
In a quick call or online query, homeowners can find out how their mortgage servicer handles additional funds combined with a regular payment.Verify your new rate (Jul 4th, 2020)
Should extra mortgage payments take first priority?
Before embarking on a prepayment plan, you might want to consider more advantageous alternatives, says Jeff Rose, a certified financial planner in Carbondale, Ill.
“A mortgage is just about the cheapest money you will ever borrow, with today’s rates at or below 4%. If you have other high-interest debt—such as credit cards or personal loans—I would pay those off first before prepaying my mortgage,” Rose says. He adds that the mortgage interest you pay is tax deductible—by prepaying your principal, you’ll pay less interest and, thus, get less of a tax write-off over the life of your loan.
“I recommend people prioritize their extra money in this order: pay down credit card debt, save six- to 12-months worth of income in a rainy day fund, invest in a 401(k) where your employer matches your contribution, then either pay down your house or look at other retirement contributions,” says Huettner.
In addition, homeowners with low rates might make more money in other investments than they could by paying down their sub-4% mortgage.
Refinancing is an effective cost-saving strategy
Another option is to refinance your mortgage to a shorter term, especially if you can lock in at a rate lower than your existing rate.
“This is like a forced savings plan where you’ll be committed to a monthly payment for a shorter term instead of only making occasional prepayments on your current term,” Huettner says.
He presents a compelling scenario. A homeowner is two years into their thirty-year mortgage of $200,000. He then refinances into a 15-year, dropping his rate by one percent. He would save over $85,000 in interest.
“If you need to keep cash liquid and you want to pursue other investment opportunities, you might not want to pay the mortgage down faster, especially if you have a low interest rate,” recommends van den Brand. “However, if you’re staying in your home for the long-term or you plan on keeping the home as a rental property, savings tens—sometimes hundreds—of thousands of dollars in interest can be a smart move.”Verify your new rate (Jul 4th, 2020)
Paying extra on your mortgage ties up cash
Rose says the best prepayment prospects are usually young or older homeowners who aren’t raising children.
“With children at home, you have a lot more expenses and things to save for, so paying the minimum on the mortgage and putting the rest into retirement and college savings funds usually makes the most sense,” says Rose.
“But if a borrower has the available funds, I usually recommend they make at least one prepayment amount each year. And for anyone close to retirement, they should focus on prepaying to get their house paid off before they retire, which can make a huge difference in their standard of living down the road.”
Michael Foguth, founder of Foguth Financial Group in Howell, Mich., however, cautions against shorting yourself and scraping by every month in order to pay off your mortgage early.
“Remember,” says Foguth, “that the equity in your home that you earn earlier is only good for cash when you sell or borrow,” such as when you open a cash-out refinance or home equity line of credit.
Before sending extra payments to your lender, make sure your mortgage is eligible for extra payments without penalty.
Examine all your options and determine which strategy – making extra payments or investing in other things – works best for your situation.
What are today’s rates?
Mortgage rates are hitting new lows. Many homeowners will discover that a refinance will save them significant amounts in interest, even if they decide not to make extra payments.
Get a rate quote for a refinance, and check ultra-low ten- and 15-year rates to further increase savings.Verify your new rate (Jul 4th, 2020)