When you prepay your mortgage, it means that you make extra payments on your mortgage principal. Prepaying can save you thousands of dollars in interest, pay off your loan early and build equity faster.
There are several ways to prepay a mortgage:
Apply a lump sum after an inheritance or other windfall.
Make an extra payment every year.
Add extra dollars to every payment.
Some combination of the above.
The benefit of prepaying your mortgage isn’t just in reducing the monthly interest expense a tiny bit at a time. It comes from paying down your outstanding loan balance with additional principal payments, which slashes the total interest you’ll owe over the life of the loan.
An amortization schedule can help you figure out the impact of additional principal payments on your loan.
This works with Mortgages, student loans, small biz loans, car loans, etc.
There are potential downsides to prepaying. For starters, typing up your cash in your home means you have less liquidity and wiggle room in your budget. In other words, you’ll have less readily available cash to put toward increasing your 401(k) contributions or paying down high-interest debt. These financial goals could offer a higher return on your investment.
Another consideration is the opportunity cost of not having that extra money invested elsewhere. Over the past 4 decades the stock market has returned an average of 10 percent a year. For the broad bond markets, the average annual gain has been close to 8 percent.
When asking yourself, “Can I prepay my mortgage?” look at your entire financial picture. Here are some important questions to consider: -Is your monthly budget tight after meeting necessary expenses?
-Is your income variable and/or unpredictable?
- How long do I plan to stay in my home?
- Are you saving enough for retirement?
- Do you have an adequate emergency savings fund of three to six months of household living expenses?
- Do you have a lot of high-interest credit cards or loans?
Assessing financial goals, income & budget can help you decide whether it makes more sense to address other financial concerns before paying ahead on your mortgage. (See our Zero Balance Budget Challenge)