As much as you love your new condo, you sure are paying a lot of interest on your mortgage. You’ve heard that it’s possible to pay extra principal each month – and that there are benefits to doing so, including reducing your overall interest payments. Is this true? How does it work?
Assuming you have a fixed-rate mortgage and there are no pre-payment penalties, paying extra principal is simple: write the extra amount you’d like to pay in the proper box, add it to your required payment, and pay the new total amount. You can pay extra each month, or just when you have the spare cash – it’s up to you, but for real benefits, pay extra consistently.
What happens is this: you reduce your principal more quickly and thus you reduce the amount of money on which your lender can charge interest. In the long run, this can save you lots and lots of money – in fact, it can reduce the length or your mortgage by years. (Yes, years!)
At Bankrate.com, you can calculate exactly how much you’d save by paying extra. In one example, one of Bankrate’s experts noted that if you pay $100 extra a month on a $100,000/30 year loan at 4.5%, you’d end up reducing your loan term by 8.5 years at a savings of $26,377.76!
Even small amounts like an extra $10 or $15 a month can add up over time. So why shouldn’t you pay down extra principal? Like anything, there are pros and cons.
Save money on interest. Long term, you’ll be paying less interest, thus saving boatloads of money over the life of the loan. This is the large and significant benefit, particularly if you’re planning on staying in the same place for a while.
A way to build more equity. Because you’re paying down the principal, you own more of your home each time you pay extra. In practical terms, this means that when you go to sell, even if you’ve not paid off your loan, you’ll get more money back in the transaction, since the bank owns less of your property.
An easy way to earn a return on your money. You’ll note that you’re doing two things when you pay extra principal. First, by paying extra, you’re literally putting money aside that you’ll eventually recoup when you sell. Second, by reducing your loan amount, you’re paying less interest.
In other words, you’re not just squirrelling away money – you’re getting a fairly nice rate of return on your extra payments. This is a great benefit, particularly because it requires very little effort or advanced investment knowledge to get a decent return.
Paying extra principal incurs no obligation. Say you’ve paid an extra $200 a month for two years … and then suddenly your financial situation changes for the worse. You can simply resume paying the required minimum amount and have that be that – you’ll still benefit from what you had paid, but you’ll not be required to continue to pay extra.
Even a little bit helps. Even if you just round up and pay to the nearest $100 – say instead of your $965 required payment, you pay $1,000 – you’ll still get some benefit, with almost no downside. It’s a great way to save a few dollars here and there painlessly.
You need extra money to pay extra principal. If you’re just barely able to afford the mortgage, paying extra principal is not easy, nor necessarily wise. Make sure your other finances are in order first.
Your required monthly payment will stay the same. While you’ll save money, you won’t see it in the form of a reduced required monthly payment. Rather, you’ll see a higher proportion of your monthly payment going towards principal.
This is a non-liquid way to save money. That extra money you’re putting towards principal will eventually cycle back to you. But, if you need it all of a sudden – say your car breaks down and you have an expensive repair bill to cover – you can’t get it back until you sell the home. So you need to make sure you have liquid assets first, before you stretch yourself to pay down more of your mortgage.
You likely get a tax break on interest anyway. Keep in mind that if you itemize your tax return, you can often deduct your interest payments – thus reducing your tax burden and making the interest payments somewhat less painful. So, while you’ll still be better off paying down more principal, the savings aren’t quite as sweet as they may seem.
You may be able to earn a better return elsewhere. When you put down extra principal, you’re saving money by not paying as much interest. But what if you took the extra money you’d planned on devoting to extra principal, and used it to invest in the stock market? And what if you made a 10% return in the market? Well, that’s almost certainly a better (though not guaranteed) return … so if you’re a savvy investor, you may want to use your spare cash elsewhere.
This strategy really depends on how high your mortgage interest rate is – if it’s high, say 8% or 9%, it’s going to be far more advantageous for you to pay down as much principal as possible. Whereas if you secure a mortgage at 4%, it won’t be quite as clear-cut – you may instead want to use your extra money in other investments.
The most satisfying savings are long term. Yes, you’ll save money if you pay extra principal. That’s guaranteed. But, if you sell after six years, you’ll not get the pleasure of paying off your mortgage early. Instead, the savings will always feel abstract, even if they’re real.
If you have the cash, it’s probably worth putting down a little extra a month (think $100 or so) towards your principal. It won’t hurt anything, you’ll build your equity faster and you’ll avoid paying as much interest to the bank.
That said, if you have other, more pressing financial obligations, paying extra on your mortgage should be the last of your concerns. Developing a rainy-day reserve, paying down credit card debt and saving for retirement are just some of the things that should take precedence. Paying extra principal is a great financial move – but only if you’re already on solid financial footing.