Should you prepay your mortgage?
Julie Garton-Good, GRI, DREI

One of the smartest ways to make your home affordable is to whittle down that thirty-year loan! Yes, you can save a few hundred dollars on your utility bills by adding weather stripping and additional insulation, but if you want to save ten of thousands of dollars over the life of owning your home, start right now on a program to cut years off your mortgage!

When does prepaying your mortgage make sense?

Prepaying your mortgage may make sense for you if you identify with one or more of the following:

  1. The interest deductibility does not have a large impact on your tax picture: While deductible interest is a nice perk, it's very rarely the reason someone would not choose to pay off their high-interest rate mortgage.
  2. A change pending in your financial future: Based on what's going to occur (putting a child through college, funding your retirement), you realize that not having that mortgage would give you greater financial flexibility.
  3. You have no plans to sell the property in the near future: This is a mistake many people make--they don't estimate how long they'll keep the property (and the loan that's on it!) Consequently, they use large sums of savings, or investment money to pay off a mortgage, just to move and need another loan! If you don't anticipate moving in the near future or refinancing into another loan, paying off this mortgage may make sense.
  4. Making the mortgage payment is a financial burden: Have you had difficulty keeping up with the payments? Are you concerned that it will mar your credit picture? Or worse yet, are you concerned that over the long-run you may risk losing the property for non-payment? If you receive an unexpected windfall (such as an inheritance or a financial settlement), you may want to consider prepayment of your mortgage.

When does prepaying your mortgage notmake sense?

Yes, there are times when prepaying your mortgage is not the best way to use your cash. See if you identify with any of these situations:

  1. Would it deflate your financial cushion should times get tough? Why would you use precious cash to pay off an interest-deductible mortgage when it would leave you without the recommended three to six months worth of savings for emergencies? Make prepaying the mortgage just one part of your financial game plan--not the entire plan.
  2. Do you have other high-rate non-deductible interest you're paying? I'm amused when people say, "Every month, I'm prepaying a little something on my mortgage--it makes me feel much better than paying all the high interest I owe on those credit cards!" What's wrong with this picture? Prepaying the mortgage may make you feel better, but it makes no financial sense to do so before you've paid off that non-deductible high-rate interest on credit obligations. Once again, make prepayment part of an overall financial plan, not the SOLE plan.

Design a systematic plan for prepaying your mortgage

Okay, you've weighed the pros and cons and feel that it's definitely in your financial game plan to prepay your mortgage. How do you begin? The answer: Carefully, because without a system for at least monitoring how and where your prepayments are being applied, you may come to the end of the year or to what you think is the end of the loan amazed at the bookkeeping errors that have occurred!

Here's why. Without proper notations, prepayments may be applied to: advanced interest, non-existent late penalties, impound accounts--who knows? And since many payments are posted electronically today, these errors may actually be made by a computer--and you know what that's like to untangle!

So here's a systematic approach to keep your prepayments on track and your sanity intact!

When making prepayments on your mortgage:

  1. Ask the lender (or other real estate professional, like your REALTOR®) for an amortization schedule for your loan. Your lender can provide you with a printout, showing payments for the life of the loan, complete with a breakdown of principal and interest for each;
  2. Choose a prepayment system that works for you. Some feel that paying a little each month is the most effective since it sets a pattern, like a forced savings account. Others like to earmark their annual income tax return to pay down the loan. Whatever you choose, make sure it sets a pattern you can live with;
  3. Here's a monthly program that works well. Looking at your amortization printout, you pay your January payment of $878 principal and interest. Then for your prepayment, you look ahead to the February principal reduction amount of $45.04 and you pay it. You have just prepaid the next month's principal! In essence, you have eliminated one full payment from your loan since the payoff figure would correspond to the balance as of the February payment. Done systematically, you can cut years off your loan! Note that the prepayment amount can be anything; that's why some borrowers prefer to make a set amount of prepayment monthly, say $50;
  4. CAUTION: Just because you have prepaid the principal for the February payment does not mean that you don't have to make a February payment. Missing payments could put the loan in default--how's that for counter-productive?
  5. I suggest you make your prepayments in a separate check (be sure to list your mortgage account number on it). That way you can tally them up at year's end and make sure they've been properly applied. Be sure to mark prepayments on your payment coupon; if none is available, mark on both the check and on a note the words, "to be applied to principal."
  6. Ask the lender for an annual loan payment printout. Although you may have to make a special request, if you're making prepayments, it's vital that you review your statement on an annual basis to make sure that the principal balance has been appropriately reduced.
  7. When is the best time to prepay the loan? While anytime is fine, prepaying in the early stages of the loan (when the majority of the payment is interest) makes the best financial sense.

Done for the right reasons (and in the correct fashion), prepaying your loan can save you thousands of dollars of interest--and give you peace of mind.