The ins and outs of paying down a mortgage
Julie Garton-Good, GRI, DREI

Q:We have a new $100,000 (8 percent) mortgage and made a New Year's resolution to pre-pay a certain principal amount every month. Is there a system that can help us do this?

A:By applying a mere $25 a week extra to your mortgage, you can pay it off a decade early and save more than $62,000 in interest. Now that's frugal!

You are correct about finding a system and sticking to it. People who do this religiously (not just when they have the extra funds) are much more likely to reap the benefits, and be glad they did.

One system I find effective is to obtain a printout of your mortgage payments (1-360), broken down into principal and interest amounts. (Your lender, real estate professional or local bank can do one for you.)

Let's use your $100,000 loan with monthly payments of $733.77 as an example. The first number on the amortization printout is the payment number (#1), followed by the interest due for that month ($666.67), the amount applied to principal ($67.10) , then the loan balance ($99,932.90). To prepay, merely add the next month's principal payment ($67.55) to your regular payment of $733.77 so that your loan balance is actually $99,865.35!

Not only will this system keep you committed to prepaying, but you will have a running total of where your loan balance is at all times. In addition, request an annual printout of your mortgage payments from the lender, and compare your records to those of the lender.

Q:How can I alert the loan servicer to the fact that I'm making a prepayment on my loan? There's no box to check on my payment coupon and they keep missing them.

A:Besides "inventing" a prepayment box on your payment coupon, make the prepayment in a separate check. Not only will that be tougher to miss, it will give you a running record of your payments if the lenders does miss it. Be sure to write on both the coupon and your separate check the words "principal prepayment."

Q:We decided a year ago to make prepayments to our mortgage. When we tallied up the checks at the end of the year, they had waited two months to credit the first two. We want to sue!

A:It's unfortunate that you didn't get immediate credit for prepaying your mortgage. But I doubt it's financially worth suing the lender over the added interest. However, they should be willing to credit the mistake.

Your loan could specify a minimum prepayment amount, so they were holding the first checks until they reached that minimum.

To insure that future prepayments will be properly applied to your loan, here are some steps to take.

First, contact the lender via certified mail. Inform them of the incident and ask the following questions: 1. When can prepayments be made and what is the suggested way to do this? (e.g. separate check or itemization on regular payment coupon); and 2. Is there a minimum prepayment amount? Also request that you receive both a receipt back for the prepayment and an annual printout showing the principal reduction on your loan. You may have to make multiple requests and/or pay a small fee for this service, but it would be worth it.

Q:I just received some inheritance that would pay off my 7 percent mortgage. How can I evaluate if this is a good financial move?

A: On the surface, paying off a mortgage sounds like the answer to anyone's prayers. But like any other business decision, it should be done only after careful consideration of the following:

  1. Is the payment a financial burden? Have you ever missed a payment or made several payments after the due date? It's wise to eliminate the debt if it's a struggle to pay, could hurt your credit or risk you losing the property;
  2. Do you have substantial financial reserves that could carry you through a financial downturn? Most financial advisors suggest you have enough money to cover six months of living expenses;
  3. Do you have other high-interest rate loans or credit accounts that should be paid off first? It makes little sense to pay off an interest-deductible mortgage when you're paying interest on other loans--probably higher--that's not deductible.

But you may decide not to pay off the loan based on answers to these questions:

  1. Where could I invest the money that might give me a better return? Would an investment generate enough return to help off-set the current mortgage payment?
  2. What are the long-term cash needs for my family's future, including college tuition and retirement?
  3. How long do I plan on keeping the property? Retiring a mortgage at 7 percent may not make financial sense if you're going to buy another house and replace the loan with a higher-rate one.

Lastly, don't forget the peace of mind afforded when a home is free and clear. That may be tough to factor in, but shouldn't be discounted.

Q: I recently refinanced my 9 percent, $85,000 loan into one at 7 percent. Now that my interest rate is lower, will it make sense to prepay the loan like I did before?

A: Your question brings up the point that there's less savings in prepaying a lower interest rate loan; but even though you'll save less, you'll still save.

Here's an example. Prepayments of $75 per month on your old 9 percent loan would save you more than $60,000 in interest over the life of the loan. But the same monthly prepayment on a 7 percent loan would reduce that savings to less than $40,000.

Does this mean that prepaying is less valuable? Not really, since what we're saving is not taxable, so our yield is actually greater than 7 percent, somewhere closer to 9 percent. Not a bad yield for such a low risk.

Don't forget that the extra equity you're building by prepaying can provide added leverage in the future. It can mean a larger down payment when you purchase again, the ability to qualify for a larger home -- all silently compounding right now in your equity nest egg.