The excerpted article was written by Rebecca Lake | SmartAssest
If you can afford to pay off your mortgage ahead of schedule, you’ll save some money on your loan’s interest. In fact, getting rid of your home loan just one or two years early could potentially save you hundreds or even thousands of dollars. But if you’re planning to take that approach, you’ll need to consider if there’s a prepayment penalty, among
Basics of Paying Off a Mortgage Early
Many homeowners would love to fast forward to when they own their houses outright and no longer have to worry about monthly mortgage payments. As a result, the idea of paying off their mortgage early could be worth exploring for some people. This will allow you to lessen the amount of interest you’ll pay over the term of your loan, all while giving you the ability to become the home’s full owner earlier than expected.
There are a few different methods by which you can go about paying early. The simplest method is just to make extra payments outside of your normal monthly payments. Provided this route doesn’t result in extra fees from your lender, you can send 13 checks each year instead of 12 (or the online equivalent of this). You can also increase your monthly payment. By paying more each month, you’ll pay off the entirety of the loan earlier than the scheduled time.
If you’re considering paying off your mortgage ahead of time, make sure you avoid these five critical mistakes.
Mistake #1: Not Considering All of Your Options
It can be very tempting if you come into some extra money to put that toward paying your mortgage off ahead of time. However, getting out of debt a little bit earlier may not be the most remunerative choice to make. To illustrate this, let’s look at an example.
Let’s say you’re considering making a one-time payment of $20,000 toward your mortgage principal. Your original loan amount was $200,000, you’re 20 years into a 30-year term, and your interest rate is 4%. Paying down $20,000 of the principal in one go could save you roughly $8,300 in interest and allow you to pay it off completely 2.5 years sooner.
That sounds great, but consider an alternative. If you invested that money in an index fund that represents the S&P 500, which averages a rate of return on 9.8%, you could earn $30,900 in interest over those same 10 years. Even a more conservative projection of your rate of return, say 4%, would net you $12,500 in interest.
Everyone’s financial situation is unique, and it’s very possible that the notion of being out of debt is so important to you that it’s worth a less than optimal use of your money. The important thing is to consider all of your options before concluding that paying off your mortgage earlier is the best path for you.
Mistake #2: Not Putting Extra Payments Towards the Loan Principal
Throwing in an extra $500 or $1,000 every month won’t necessarily help you pay off your mortgage more quickly. Unless you specify that the additional money you’re paying is meant to be applied to your principal balance, the lender may use it to pay down interest for the next scheduled payment.
If you’re writing separate checks for extra principal payments, you can make a note of that on the memo line. If you pay your mortgage bill online, you might want to find out whether the lender will let you include a note specifying how additional payments should be used.
Mistake #3: Not Asking If There’s a Prepayment Penalty
Mortgage lenders are in business to make money and one of the ways they do that is by charging you interest on your loan. When you prepay your mortgage, you’re essentially costing the lender money. That’s why some lenders try to make up for lost profits by charging a prepayment penalty.
Prepayment penalties can be equal to a percentage of a mortgage loan amount or the equivalent of a certain number of monthly interest payments. If you’re paying off your home loan well in advance, those fees can add up quickly. For example, a 3% prepayment penalty on a $250,000 mortgage would cost you $7,500.
In the process of trying to save money by paying off your mortgage early, you could actually lose money if you have to pay a hefty penalty.
Mistake #4: Leaving Yourself Cash-Poor
Throwing every extra penny you’ve got at your mortgage is an aggressive way to get out of debt. It could also backfire. If you don’t have anything set aside for emergencies, for example, you could end up in a tight spot if you get sick and can’t work for a few months. In that case, you may have to use your credit card to cover your bills or try to take out an additional loan.
If you don’t have an emergency fund, your best bet may be to put some of your extra mortgage payments in a rainy day fund. Once you have three to six months’ worth of expenses saved, you may be able to focus on paying down your mortgage debt.
Mistake #5: Extending Your Loan Term When Refinancing
Refinancing can save you money in multiple ways, as it allows you to convert to either a shorter or longer loan term, depending on what’s best for you. So if you’re 10 years into a 30-year mortgage term, you could potentially refinance to a 10-year term and shave off 10 years. On the flip side, you could go for another 30-year term to lower your monthly payments.
However, loans with shorter terms tend to have lower interest rates, allowing you to both save on interest and reach full ownership much sooner. In some cases, though, refinancing could cost you more in the long run, especially if you’re planning to extend your loan term. Before you refinance, it’s a good idea to crunch some numbers and figure out whether having a longer mortgage term really makes sense.
Don’t forget closing costs either. If your lender agrees to let you roll those costs into your loan, you could end up paying more money. After all, you’ll now be on the hook for interest on a larger loan amount.
Whether you should pay off your mortgage early ultimately depends on how much money you have to spare, what your alternatives are and other factors that are unique to you. But if it’s something that’s legitimately on your radar, make sure to seriously consider all of your options.
Although often known for their expertise in investing and financial planning, many financial advisors are knowledgeable about mortgages and home purchases. So if you’re struggling to make a decision on your own, consider consulting with a local financial advisor.
Tips for Buying a Home
- To guide you through a major financial decision like the purchase of a home, you may want to talk to a financial advisor. Luckily, SmartAsset’s advisor matching tool can help you find a suitable financial advisor in your area to work with. Get started now.
- Securing a mortgage can be a stressful and confusing process. For starters, you need to figure out what term is best for you, whether you want a fixed or variable interest rate and where to get the best mortgage rates.