Investigating the Potential
A homeowner who is considering their options for paying their mortgage off early should first look at some of the practical reasons why this may not work for them. There are some instances when a monthly mortgage payment may actually save a homeowner money. Before deciding that you want to pay your mortgage off early, these items should be carefully reviewed.
Prepayment penalty – Before homeowners decide to start paying extra money to reduce their mortgage, they need to carefully review their mortgage contract. Some mortgage contracts will contain prepayment penalty clauses that can be very expensive. Some contracts have short penalties (e.g., for loans paid off during the first five years), while others have a built in clause that may result in steep fees even if the prepayment is done sooner than the completion of the thirty (or twenty) year agreement. This is the first thing that anyone who is considering an early repayment should consider.
Tax implications of early payoff – Reviewing your current tax status is another important step before making the decision to pay off a mortgage early. Many homeowners receive a credit on their taxes for interest paid on their mortgage. Those who are considering an early payoff should first determine how much money they are saving on their taxes. The increased tax burden of losing the mortgage interest deduction may mean that over time, a homeowner is not saving as much as they hoped.
After these evaluations are done, if it still makes sense, then a homeowner can decide which payoff strategies work best for them. Here are a few options to consider.
Extra Annual Payments
While many mortgage companies now offer the homeowner an option to pay their mortgage every two weeks instead of once a month, there is often a fee involved. Rather than pay the additional fees, a homeowner can undertake this payment method on their own. First, it is important to remember that if this is done at the beginning of cycle, the monthly payment should be made on time. Here is what a typical plan may look like.
Decision made – You have made the decision to begin paying off your mortgage earlier by making payments twice a month instead of once a month. To do this, you will divide your current mortgage payment in half and send one half every two weeks. Through the course of the year, instead of making 12 payments, you will have made 26 payments. In reality, this means that you have made one full extra payment throughout the year (12 X 2 = 24, 26 – 24 = 2 and 2 = one full payment). Let us assume that you have made this decision in August.
First payment – In order to ensure that you do not fall behind on your mortgage, you will have to make your first full mortgage payment on the regularly scheduled date. For most homeowner's this will mean that on the first of the month, you will make a full payment. Assuming that your mortgage payment is $1,200 a month, you will mail the mortgage company another payment of $600 in the middle of the month (1/2 payment), and then another half payment at the end of the first month which will pay the mortgage for following month.
After 12 months – Since there are 52 weeks in a year, by the same month of the following year, you will have made 26 half payments on your mortgage. This means that you have paid 13 months of full mortgage payments. Most homeowners will then need to contact their mortgage company and ask that they recalculate the amortization on the loan. There are specific reasons for this: (a) it may reduce your overall payment since you have reduced your overall indebtedness and (b) those who have been paying personal mortgage insurance (PMI) may be eligible to have it removed from their mortgage.
Important note: It is important that the lender understand that the extra payments are to be placed towards the principal of the loan. If a homeowner does not specify this, the lender may simply continue to debit the overall burden.
When Windfalls Can Help
There are some life events that can help you pay your mortgage off sooner than anticipated. Not every homeowner will be able to take advantage of them, but here are a few ideas that may help.
Annual bonuses – For those who receive an annual bonus from their company, taking all or a portion of that bonus and sending it along to their mortgage company (with a notation that it is to be used for paying down principal amounts) can reduce their overall mortgage indebtedness. Since many of us cannot count on a specific amount for a bonus, this can be a great way to make use of unexpected funds.
Income tax refunds – Annual income tax refunds can also be used to pay down the principal on a mortgage. Homeowners may want to consider claiming at a higher withholding rate (e.g., single versus married, fewer dependents etc.) to ensure that they will receive a refund. These amounts can then be sent to the mortgage company to pay off the mortgage sooner.
Annual raises – When most of us get a raise at work, we simply incorporate the additional funds into our monthly budget. However, since a pay increase means we are getting additional money in our paychecks, we've been accustomed to living without that amount. Instead of increasing our budget, it is a good idea to consider using these funds to reduce the overall amount of our mortgage. Sending in an additional monthly payment (properly notated to be credited towards principal) can save a lot of money over time. This is a simple (and nearly painless) money-saving mortgage payoff tip.
Buying a home is exciting, but the reality of paying a mortgage for thirty years is often very intimidating. These are just a few of the options that a homeowner can explore to pay off their loans sooner. Most homeowners should keep an eye on interest rates and if they have been paying down their principal amounts, they may be able to refinance their home at not only a lower interest rate, but they may also be able to change their mortgage term from a 30 year loan to either a 20 year loan or a 15 year loan.
- Gibbs, Lisa Money Magazine; CNN Money Should you pay off the house? http://money.cnn.com/2011/02/22/pf/saving/pay_off_mortgage.moneymag/index.htm
- Image Credits:
Investigating Options Purchased from istockphoto.com/koun
Calculations Purchased from istockphoto.com/koun
Windfall Purchased from istockphoto.com/frentusha
- McWhinney, James E Investopedia Paying Off Your Mortgage http://www.investopedia.com/articles/pf/05/payoffmortgage.asp#axzz1ULNifTSw