Pre-paying your mortgage means paying all or some of the money before the mortgage is due. The process is very simple, you make additional payments towards the principal of the loan early. The payments can be made through paying a lump-sum, paying an extra standard monthly payment, or making bi-weekly mortgage payments in one month for a total of 13 annually. However, a cost-benefit analysis is necessary to see if pre-payment is best for you.
What to consider before mortgage pre-payment?
To decide mortgage pre-payment, look at it in terms of cash flow:
If you have enough savings to support you if you are unemployed of 6 months, pay your insurance bills, and for home repair and maintenance, then you can consider mortgage pre-payment.
If you don’t have enough equity and a plan to obtain a reverse mortgage, then having the cash in a retirement plan is a better option.
Is your home an investment?
Homes are not seen as good investments, so adding to your principal to increase your equity may not provide any return. Your home-equity growth should be able to beat inflation, for pre-payment. If you plan to move, then you should never go for mortgage pre-payment.
Mortgage Pre-payment Restrictions:
While the terms of some mortgages allow you to prepay the loan without restrictions, other mortgages have restrictions. You may face a penalty for pre-paying your mortgage, especially if you pay it before 5-years. This mainly because pre-payment, reduces the lender’s profits.
Another penalty is that lenders don’t consider a sale of a home a prepayment and others allow you to pay up to a certain amount before the penalty kicks in. To avoid the pre-payment penalty, read the pre-payment disclosure before signing the mortgage document.
Benefits of Pre-payment:
Mortgage pre-payment has the following benefits:
- You’ll pay less money overall in interest: the more money you put towards the mortgage, the lower the interest you’ll have to pay.
- You’ll pay the mortgage faster: Paying the principal faster will allow you to pay the loan faster, so you’ll be mortgage-free sooner than scheduled.
- It is like an investment with guaranteed financial return: Financial assets are more expensive and riskier for investment. Mortgage pre-payment will give you a higher return with less risk.
Drawbacks of Pre-payment:
Mortgage pre-payment also has various drawbacks:
- Less liquid assets: If you pre-pay monthly, most of your salary will go towards the mortgage, leaving less liquidity for other needs.
- Slows down wealth build-up: inflation is likely to rise in the upcoming years, and during this period you want to be a debtor rather than a creditor, because, as the dollar depreciates, the real value of the mortgage will decline also.
- Less tax savings: mortgage interest payments provide tax savings, but if you pay down the mortgage, your interest will decline and so will your tax shields.
What should you do?
Before mortgage pre-payment, look at your goals. If your goal is to pay less money to the lender in the long-run, then both refinancing and mortgage prepayment are equally plausible. If your goal is to reduce your monthly payments, then go for refinancing and if you want to pay off your mortgage quickly, then go for pre-payment. However, make sure you look at the financial aspect before deciding. For example, if you have high credit card debt, don’t opt for prepayment. There are no wrong or right answers when it comes to mortgage refinancing, it all depends on your goals and financial situation.
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