HSH.com’s ‘One Big Idea’ for 2012: Prepaying your mortgage
So record low interest rates proved a siren song for you in 2011, and you refinanced. Whether you hit rates at rock bottom or somewhere above them, you got a great opportunity to save money by slashing interest payments. Good for you!
But your work may not be done. If you haven't considered committing some of your interest savings to paying down your loan, you may be missing a great chance to save even more money, not to mention rebuilding your equity position faster, giving you a thicker buffer against wobbly home prices.
Why should you prepay your mortgage?
There are a number of reasons to prepay your mortgage. As noted above, building equity more quickly is one. Saving more money by terminating your loan sooner--or, in the case of an adjustable rate mortgage, making future interest rate increases less painful--is another. If you are considering banking the monthly savings from your refinance, that's great, except most savings accounts, or "liquid" investments like CDs, will earn you very, very little.
In the case of prepaying your mortgage, the savings can be much greater than what a savings account or CD can generate since you will be "earning" whatever the after-tax interest rate is on your mortgage.
Why you’ll earn more by prepaying
Here’s a simple example: You have a 4 percent mortgage and you are in a 25 percent tax bracket. If you itemize, you are allowed to deduct some of the interest expense from your taxes, so your after-tax cost is 3 percent. If you prepay your mortgage, the amount of money on which you'll be charged that 3 percent grows smaller all the time, and any portion that's paid off is charged no interest. You've just "earned" 3 percent on every dollar you've paid off!
Your prepayment doesn't need to be a huge amount. Simply rounding up your monthly payment to the next $10 or $25 increment can be enough to make a considerable dent over time in a fairly painless fashion. Of course, you could simply pay one lump sum every year, perhaps from a bonus or even a portion of any tax return you might receive.
Optimize your refinance by prepaying
If your refinance resulted in a new term which added to the time over which you'll be paying your mortgage--for example, you had 27.5 years remaining on the old loan and got a new 30-year term--the only way to fully realize the savings from the new, lower rate is to make payments on your new loan as though it has only a 27.5-year term, not 30. The extra two plus years of interest compounding can seriously crimp your refinance savings.
Alternately, if you've got your heart set on owning your home free and clear at a given point in the future, you can actually create your own mortgage term with the proper prepayment to reach your goal.
Here’s a prepay example: The original $200,000, 30-year fixed-rate loan at 5.25 percent was taken out in March of 2009 and refinanced in September 2011 to a new 4 percent, 30-year fixed-rate loan ($192,401.23 balance with $26,637.94 already spent on interest):
Prepaid at 27.5 yr. term
Total Loan Term
* includes interest on original loan paid over first 29 months
You'll note that paying your new loan over your old loan's scheduled remaining term--27.5 years--will save you an additional $13,147.23 over keeping it at a 30-year term. All that for less than $44 per month!
While prepaying works for everyone, we realize that there might be better "returns" from paying down high-interest credit card debt, or student or installment loans. Even shoring up your cash safety net should take precedence over prepaying. That said, while prepaying your mortgage today might not be your first consideration, you should still consider it all the same. After all, the greatest savings come from prepaying early in your mortgage term, so the sooner, the better!
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