How to Prepay Your Mortgage and Should You Really Do It?
When I got my mortgage, I knew I wanted to make extra principal payments because 30 years of payments scared me. Considering I wasn’t even 30 years old, 30 years of payments was an insane commitment and I wanted out of it as soon as possible, while still keeping the house, of course.
I had heard many times and even proved through amortization schedules that making one extra payment a year cuts your mortgage by about 7 years. Great! That seemed simple enough.
How Bi-Weekly Payments Work
Instead of one large extra mortgage payment per year, many people do bi-weekly payments, which effectively is the same thing. If you are paying $1,000 a month for your mortgage and switch to bi-weekly payments at $500 every two weeks, you’ll be paying $13,000 over the course of a year instead of $12,000.
The Math:
Monthly payments: $1,000 per month x 12 months = $12,000 a year
Bi-weekly payments: $500 every 2 weeks x (52 weeks per year/2 is 26 payments) = $13,000 a year
The mortgage company thinks this is easy, too. They started marketing to me immediately that they could sign me up for a service to handle my bi-weekly payments for the low cost of $2/payment, which equals $52 extra per year.
Well, that kind of annoyed me. Why should I pay them to take my money more often? I started looking around for alternative solutions to this. My requirements were that it had to be an automated solution and I didn’t want to pay for the solution.
The One-Payment-A-Month Method
For the automated portion of my requirements, my mortgage company would only make one payment per month that was automated, but it could be distributed any way I wanted (between monthly payment, extra principal and escrow). Anything more than one payment per month would have to be manual, thus not meeting my requirement. My solution was to take that extra mortgage payment per year that I wanted to make, divide it by 12 and that’s how much extra I wanted to pay per month. The mortgage company’s website gave me the option of adding on an extra principal payment per month along with my normal payment and that’s exactly what I do.
Since I like nice, round numbers, I round up my total payment (mortgage payment + extra principal) to next $100.
The Math:
Monthly mortgage payment = $2,148.33
Extra principal required to make one extra mortgage payment per year: $2,148.33/12 months = $179.01 a month
Total mortgage payment + principal = $2,327.34 a month
Rounded to next highest $100 = $2,400 a month
My new extra principal payment = $2,400-$2,148.33 = $251.67 a month
So far, so good. I can see the difference it makes because my mortgage company keeps track of how many payments I would normally have left on my mortgage vs. how many payments I actually have left after my prepaid principal.
I should have 320 payments left but instead, I only have 290. The rounding up really helps, too. We’ve made 40 mortgage payments and have cut 30 off. If we keep this up, we should cut more than 7 years off of our mortgage.
Every year when my escrow payment is recalculated up or down, these numbers fluctuate a little so I use the same method to recalculate my payment. The mortgage company will only recalculate my payment but not my extra principal contributions. They stay the same until I change them.
Alternatives When the Mortgage Company Won’t Automate Extra Principal Payments
If your mortgage company doesn’t offer anything automated to allow for prepaying principal, you could try your bank’s automated bill payment. Since sometimes, banks actually do send out checks for their automated bill payment, I would probably try to at least have your regular mortgage payment be automated through your mortgage company and have your bank’s bill payment send in the extra principal, clearly marking it as “Principal Payment” in the memo or notes of the check.
Some People Disagree with Prepaying Mortgages
Some people are very anti-prepaying your mortgage because they say you should pay down your higher-rate debt first. In addition, you’ll lose your interest deduction on your taxes sooner and really, you could probably make more by investing that extra money elsewhere.
My mortgage is by far my highest rate debt at 6.25%, even if you take into account the interest tax deduction. A tax deduction, while nice, still isn’t as nice as never having paid the interest at all, in my opinion. As for being able to invest the money and do better than prepaying the mortgage, I considered that and realized that a lot of our money is tied up in our retirement accounts, which are investment accounts. I do well in them but I don’t think I’m hurting my finances by hedging my bets, here. I think we’re in pretty good shape.
Those people who don’t think you should prepay your mortgage do make some excellent points, though. If you don’t have a fully-funded emergency fund, don’t contribute as much as you should to your retirement accounts and especially if you have higher-interest debt, your money would be better spent funding those first. Those really are important and I can’t stress that nearly enough.
The Happy Ending
One of my coworkers had a great story related to this and I want to share it with you. When he bought his house so many years ago, he was paying a little bit extra each month. It wasn’t a whole lot, just a few dollars here and there. As the taxes on his home increased, he didn’t have the extra money so he stopped paying it. It was so very long ago, he had forgotten about it.
A few months ago, he sent in his mortgage check, like he does every month. First, he received a check in the mail from his mortgage company that said it was an overpayment of his escrow. He thought it was odd, but just held onto it meaning to call them when he had a chance. A week later, he received a letter from the mortgage company. He opened the envelope and out fell his last mortgage check. The letter stated that they were unable to accept payment for a $0 balance account. He was confused and thought something was wrong. He finally called them and found out that those few dollars he sent in each month when he first got his mortgage helped to pay off his house six months early!
This was the final obstacle in my coworker’s life he had to overcome before he could retire. He finally retired last month, a whole six months early, because his mortgage was now paid in full.
So here’s to Ron who has given me a great story to tell for years to come.
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February 6th, 2007 at 8:13 am
Hello Liz,
Very good article on Mortgage payment and this idea of paying little extra money is good one. The math, which you have done, is giving a clear figure of how it’s going to work. Thank you for sharing and oh yeah last but not least the happy ending story of your co-worker is going to be a dream for everyone.
February 7th, 2007 at 10:53 pm
Thanks!
What do you write on Finance Guide 101?
March 1st, 2007 at 2:30 am
Hello Liz,
I am a guest author of finance guide 101 mostly I read and sometimes I write if I find some interesting information. Well once our finance guide blogs starts then I will be writing more…
Daniel.