There has been a common practice that has gained acceptance over the past few years that pre-paying your mortgage is a good thing; and IT IS! Your goal for financial independence should be to own your home outright as an asset. Keep in mind that if you want to use that asset as a source of cash in the future you need to either re-finance to get the cash out, or have an open Equity Line that is available to you. The challenge is not with the action but the result. Let’s say for example you have a $200,000 loan on a 30 Year amortization at 4.5%. Your monthly principle and interest is $1,013. That is composed of principle and interest. In any conforming loan you pay the bulk of that payment as interest during the first half of the loan and then it flips over to be mostly principle. The bank gets their money first (nothing new here). You are paying $164,813 in interest if you keep the loan for the entire time and do no pre-pay the principle balance (this is reflected on your closing documents when you did the loan).
Now let’s say you are opposed to paying any more interest than you absolutely have to AND you have some spare cash each month from a raise in pay or a second job. You need to determine how best to use that money. You could blow it on electronics (let’s be real here, that is an option); you could put it in savings where you might earn some interest; you could pay off some higher interest bills like credit cards (not a bad choice but let us assume you have no monthly revolving debt); or you could pay down your principle balance to save on the interest and get to real home ownership faster (face it, if you have a mortgage you are renting until you actually pay off the note, the bank owns the property).
So, you want to pre-pay your loan. The question is how to do it to get the best result.
Your mortgage servicer says they can set you up for auto-draft on a bi-weekly schedule and you will pay your loan off faster. While that is technically true, let’s look at the numbers:
Your base payment is $1,013 so if you make 12 regular payments you paid $12,160 this year.
If you make bi weekly payments you pay $506 every two weeks so this year you pay $13,137.
So you paid $1,013 extra this year towards your loan. That means every year you made one extra payment towards your loan. If you continue to do this you will shorten your term by 4 years and 3 months and save 26,689 in interest over the life of the loan. Sounds good right?
Here is what you are not being told…for most servicers they take the first half of your payment out automatically and put it in an interest bearing escrow account where it waits until there is a full payment available THEN it is applied to your loan. So the servicer gets the interest on the money as it waits for two weeks. Now this does not necessarily apply to all servicers, you need to check for yourself before you agree to this.
Another option is Monthly pre-payments. If we take the above example of bi-weekly and breakdown the annual payment into the monthly you are pre-paying $85 per month extra to accomplish the reduction in term. Is that a large amount? If you eat out at a fast food restaurant and eat off the dollar menu five days a week you are spending an average of $50.00 a week on lunch; that $216.67 a month.
Could you put maybe $100.00 a month from that towards paying down your mortgage debt? If you could then you would shorten your 30 year note into a 25 year note and save $31,745.46 in interest!
Now just for churning those brain cells let’s take it one step further. Since this is a fixed rate mortgage, and we know that interest is mostly paid up front, and the monthly payment does not change only the mix of principle and interest, how about if we DO NOT make a monthly pre-payment?
YES I SAID DO NOT MAKE A MONTHLY PRE-PAYMENT…
What if instead you open a small interest bearing savings or money market account (separate from all other active accounts…this one is special). Each month you put the $100 in it. In the 12th month you check the balance and you send $1200 as a separate payment towards principle to your servicer. The interest you earned throughout the year is yours to keep. Also while paying yourself interest you have an emergency fund building value if you, for example, need to buy four new tires for the car at one time. Instead of paying double digit interest on a credit card you could use the money in that account. Keep in mind that you will not be making your annual pre-payment of $1200 on your mortgage, but you are offsetting that loss of reduction with the interest you might be paying on a credit card if you did not have the cash to pay it off at the end of the month.
But let’s assume you do not have any catastrophes this year and you make your $1200 pre-payment in the 12th month. You have just accomplished the same thing as if you made monthly pre-payments BUT you paid yourself the interest over the year and had that money available to weight against other cash uses and costs in the event of an emergency.
This is how you can shorten your term and save on interest without being required to make a higher payment on a shorter term loan.
REFINANCING TO A SHORTER TERM AND LOWER RATE
Now let’s look at another alternative. Let’s assume you got a great raise at work and now you have an extra $500 a month you could put towards principle reduction. Would the above example work best?
Same 30 year note; $500 a month prepay results in a loan term of 15 years 3 months and interest total interest paid of $76,698 – Pretty sweet right?
Instead let’s refinance into a 15 year note at say 3.5%. Payment is 1429.77 (right where you are with the pre-payment above) BUT you only pay $57,357 in Interest so you pay it off in about the same amount of time but save an additional $19,340 in interest because you were able to lower the rate and therefore the amount of interest you pay over the term.
This is why you need a professional with years of experience and knowledge to guide you through the best options for you. Not just what can we get you to say yes to today, but what makes sense two years out, five years out, 10 years out. A professional who will take the time to understand where you are financially today and what your goals are. Someone who will not only write your loan today but watch for market shifts that you could take advantage of and let you know about them regularly throughout your relationship with your mortgage professional.
At Affinity Home Lending we take great pride in the relationships we build with our customers, their friends, and families. We want to be the go-to person you reach out to when there is a life changing event like a new job or a child going to college. We want to be the first person you call when you need a referral to a service provider from our network of professionals and we want you to be confident, based on our efforts, that we are here to serve your needs first and with the highest and best results.
Terms, Rate and Loan scenarios used in this document are for example purposes only and are not an offer to lend. Each loan is different to please consult a licensed mortgage professional to see what you options are.