If Time Is Money, Then Faster Means Cheaper
How can a home that sells for a modest $160,000 end up costing more than $260,000 in the long run? Where’d that extra $100,000 come from? The answer lies in the interest that accrues over the life of a home loan.
In fact, $100,000 of interest is relatively cheap, as far as mortgages are concerned. This example assumes a full 20-percent down payment and a highly desirable 4.5-percent fixed interest rate for 30 years. If you instead bought that same $160,000 home with a 5-percent down payment and a 7-percent interest rate, the total cost would jump up to more than $360,000 — an extra $200,000 of interest!
Now that you’ve seen these somewhat startling figures, rest assured that there’s a very simple way to reduce the total cost of a 30-year mortgage: Pay it off in less than 30 years. When it comes to a fixed-rate mortgage, shortening the term means lowering the total cost.
First Things First
It’s always good to aggressively pay off debt and save money on interest, and by paying off your mortgage faster, you’ll gain the peace of mind that comes with living free and clear all that sooner. Before we get into our seven payment-accelerating strategies, however, there are a few things you need to keep in mind:
- Check for a Prepayment Penalty First: While not as common now as they once were, some mortgages have special rules in their fine print that penalize you for paying off the loan ahead of schedule. It’s something you should double-check before resolving to pay off your mortgage early.
- Specify That Extra Payments Are for the Principal: In each mortgage payment, a portion of the money pays for the interest, and another portion goes toward lowering the principal (the actual balance of the loan). Whenever you make any kind of extra payment, you have to make sure your loan servicer knows to apply it toward your principal.
- Adjustable-Rate Mortgages Get Cheaper, Not Shorter: Every time the interest rate on an ARM is adjusted, the mortgage’s whole payment schedule gets recalculated so the payoff date remains the same. Because of this, an ARM’s term will not get shorter when you make extra payments, but you will still save massively on interest.
- High-Interest Debts and Savings Come First: The most important thing to remember is that you should not be paying off your mortgage early if you have other debts to pay that have higher interest rates. Pay off the higher-interest debts first. Even then, it may be a better idea to invest your extra money in building a retirement savings account rather than paying off your mortgage earlier, if you do not already have savings set aside.
All figures are provided for example purposes only. Your own loan-payoff results will vary according to the specific terms of your mortgage.
Applying Pocket Money to Your Principal
This first trio of strategies helps you pay extra toward your mortgage as painlessly as possible:
- Round Up Your Payments: Suppose your monthly principal/interest payment is about $1,011. For the price of dinner and a movie, you could bump it up to an even-sounding $1,050. While it may mean going out one less night every month, it will also mean many fewer monthly payments to make overall.
- Reinvest Your Raises: On the other hand, if you get a raise at work that allows you to pay an extra $40 toward your mortgage every month, then you could enjoy the same long-term benefits without it affecting your present quality of life at all.
- Use Your Windfalls Wisely: If your monthly budget is too tight to round anything up, perhaps there’s more room in your yearly budget. If you happen to get a bonus at work or a hefty income-tax refund, and you find yourself with an extra $500 burning a hole in your pocket, that’s the perfect time to make an extra principal payment on your mortgage.
Let’s go back to our example in which you bought a $160,000 home with a 5-percent down payment and a 30-year mortgage fixed at 7 percent. By using any of the three casual strategies described above, you could pay off that home a full 3 years early and save more than $28,000 in interest in the process!
Staying One Step Ahead of Your Loan
If you are prepared to commit to a more disciplined approach, these next three strategies are all ways to make 13 payments every year instead of 12.
- Pay Every Two Weeks: Cutting each monthly mortgage payment in half would mean making 24 half-payments per year. Due to a nice quirk of our calendar, however, most workers get 26 paychecks every year, so if you make half a payment with every paycheck, you’ll automatically be making one whole extra mortgage payment every year.
- Pay Extra Every Month: If you aren’t paid biweekly, or your servicer doesn’t offer a biweekly payment option, you can still spread out the extra payment on your own by dividing the payment amount by 12 and adding that to each payment you make.
- Double-Pay Once Per Year: If the two methods above are too troublesome for your mortgage servicer, you can keep it simple by saving the extra money yourself and sending two checks in the last month of the year — one for the regular payment, and the other just for reducing your principal.
By making 13 payments per year instead of 12 toward our example mortgage, you could pay off that $160,000 home 6 years sooner and save more than $51,000 in interest!
Saying Goodbye to PMI
Unlike all the previous strategies, this seventh strategy is a special case where you don’t actually have to pay more every month than you already are.
When you buy a home with less than 20% down, as in our example, you are usually required to pay for mortgage insurance, which can cost you hundreds or even thousands of dollars per year. The good news is that if it’s a private mortgage insurance policy for a conventional loan, you should be able to request for it to be canceled after your loan-to-value ratio drops below 80%.
If you reduce your required monthly payment by getting rid of mortgage insurance, and then you continue making the same payment as before, you will effectively be paying extra toward your mortgage without even feeling the difference!
Note that for FHA loans, you may have to refinance your home to get rid of mortgage insurance. Once you get onto the topic of refinancing, though, then the possibilities for saving money and shortening your loan term really open up!
Think About Your Future
When you contemplate these strategies for paying your mortgage faster, consider how old you want to be when your mortgage is paid off. For example, if you bought a home in your early 30s, you might want to see how you can shave a few years off your mortgage term so you can enjoy living free and clear when you’re still in your 50s. It might be nice to free up all that money every month before you retire!