Should You Make Extra Mortgage Principal Payments?
After settling into a home or finding a little more financial flexibility, many homeowners begin asking, “should I make extra mortgage payments?” After all, making extra payments can save on interest costs and shorten the length of your mortgage bringing you that much closer to owning your home outright.
Yet, while the thought of paying down your mortgage faster and living in your home without a mortgage sounds great, there can be reasons why making extra payments toward principal might not make sense.
“Sometimes it’s good to make extra mortgage payments, but not always,” says Kristi Sullivan of Sullivan Financial Planning in Denver, Colorado. “For example, paying an extra $200/month on your mortgage to knock it down from 30 years to 25 years in a house you only imagine living in for another five years does not help you. You will tie up that extra monthly payment and never realize the benefit of it."
While many agree the thrill of living without a mortgage is liberating, you can accomplish that in more ways than one. So how do you know if it makes sense for you to begin paying a little extra principal each month on your mortgage? It really depends on your financial situation and how you manage your discretionary funds.
Two benefits of making extra payments
As you may know, making extra payments on your mortgage does NOT lower your monthly payment. Additional payments to the principal just help to shorten the length of the loan (since your payment is fixed). Of course, paying additional principal does, in fact, save money since you’d effectively shorten the loan term and stop making payments sooner than if you were to make the minimum payment. However, that only happens after a certain (and still long) period of time.
“If you have an extra mortgage payment plan that will end your mortgage within a timeframe that lets you enjoy five years or longer of mortgage-free living, that makes more sense,” says Sullivan.
So what is the effect of paying extra principal on a mortgage?
1. Save on interest
Since your interest is calculated on your remaining loan balance, making additional principal payments every month will significantly reduce your interest payments over the life of the loan. By paying more principal each month, you incrementally lower the principal balance and interest charged on it.
Peter Tedstrom of Brown & Tedstrom Wealth Management explains, “If the mortgage has a variable rate, we recommend either paying extra each month or refinancing while rates are still low.”
Unlike fixed-rate mortgages, ARM loans will reset at a predetermined length of time depending on the loan program. Paying down more principal increases the amount of equity and saves on interest before the reset period. This also increases the chances of refinancing out of a variable rate loan as the equity in the home rises.
2. Shorten the loan term
Making additional principal payments will shorten the length of your mortgage term and allow you to build equity faster. Because your balance is being paid down faster, you’ll have fewer total payments to make, in-turn leading to more savings.
(EXAMPLE: Consider your loan amount is $300,000 with an interest rate of 4% and a 30-year loan term. If you pay $150 additional toward the principal each month, you can expect to save $40,282 and pay off your mortgage almost 5 years earlier.)
Four alternatives to paying extra mortgage principal
Before you begin making extra principal payments on your mortgage, it’s best to consider your overall financial goals. Consider how long you plan on living in the home. Assess any money that you can foresee needing in the future (college tuition, a vacation, a new/used car, home repairs). And determine any current debts you are still paying on.
Assessing your current financial position and your future goals (and expectations) will help identify the ideal use for additional funds or maybe even prove that paying more on your mortgage is advantageous.
So, conversely, what are the alternatives (instead of making extra payments) and what could the benefits be?
1. Pay off credit card debt
If you’re having a hard time with credit card debt like many Americans, it’s more than likely you don’t have enough available cash to commit to paying extra on your mortgage. Your credit card rates are going to be significantly higher than your home loan interest rate so it makes sense to tackle credit card debt first. Credit cards typically carry the highest cost to borrow with an average variable interest rate of about 16%.
2. Refinance to a lower rate
This may sound strange to skip paying extra principal and refinance your mortgage instead, but it could prove to save you more and still let you keep the extra money you’d pay toward your principal for other alternatives. The idea is that you may be able to lower your current rate without resetting your term. Your breakeven point could end up being sooner than you think.
Talk with a mortgage professional to see if this might make sense for your situation. Another option is refinancing from a 30-year mortgage to a 15-year mortgage. Doing so cuts your term in half and saves you tens of thousands of dollars over the course of your loan, even if you don't make an extra mortgage payment.
3. Build up a rainy day fund
Save for an emergency. We recommend setting aside three to six months' worth of living expenses in savings in case you lose your job or incur unexpected costs. Without those financial reserves in place, you could put your mortgage in jeopardy, which includes the extra money you worked so hard to put toward it if you’re making extra mortgage payments
4. Invest in the market
You could stand to make more money by using additional principal payments and investing that money instead of depending on how long you plan to stay in the home. “You’d be better off putting an extra $200/month in an IRA,” says Sullivan.
Consider how long you plan to stay in your home. If you won’t realize the benefit of making extra payments before you plan to sell the home, investing what you would have paid extra might be a more wise choice.
“In a low-interest rate economy, mortgage rates are assumed to be at least a couple percentage points lower than what a moderate risk investment portfolio is likely to earn,” says Tedstrom.
Making extra payments on mortgage: Is it the right move?
The short answer is, it depends. Some homeowners will want to explore the possibility of a future lower mortgage payment by paying down principal now. You may feel strongly that shortening the length of your loan is ideal. Or you may want to build wealth separately and save the difference. Essentially it comes down to a few financial and homeownership goals that help you either save time, money, or a little of both.
Not every homeowner will benefit from making an additional mortgage principal payment here and there. Before doing anything else, use the above extra mortgage payment calculator and see how much you may save in the long run.
(Disclaimer: American Financing is not a licensed financial advisor. The information contained in this article is not nor should be taken as investment advice. Please consult a licensed financial professional to discuss your personal investment strategy. American Financing is not affiliated with, endorsed by, or sponsored by Sullivan Financial Planning or Tedstrom Wealth Management or any of their affiliates or subsidiaries.)