If you have a little extra money each month, you may consider paying extra towards your mortgage. Paying extra principal is a great way to get ahead. But, what exactly does paying the extra principal do for you?
You’ll Pay Less Interest
When you make extra principal payments on your mortgage, you knock down the principal balance. This is the amount you borrowed from the bank. When you lower the principal balance, you’ll pay less interest because you’ll have the loan paid off sooner.
Even just an extra $100 per month can help knock several years off your loan, not to mention several thousands of dollars in interest. Even though you won’t see the interest grow, as you would in a CD or other investment vehicle, you may come out ahead of the game by paying down your mortgage rather than investing the funds.
You’ll Own Your Home Faster
If you plan to retire without a mortgage payment, paying extra principal each month can help you get to that point. The more you pay towards the principal, the quicker you will own your home free and clear.
Even if you aren’t looking at the finish line quite yet, paying more principal up front can give you more equity in your home. The more equity you have, the better financial position you may have. Whether you need to tap into that equity at some point to fund college or to make improvements on your home or you just enjoy being mortgage-free earlier, it can be a wise choice.
How to Make Extra Principal Payments
Now you may wonder how you can make extra principal payments. For example, what if you don’t have an extra $100 or more per month to put towards your mortgage? Luckily, there are a few ways you can make this happen.
- Pay extra each month – The easiest method is to come up with a set amount of ‘extra funds’ you’ll put towards your mortgage each month. There isn’t a set amount. While $100 each month would be nice, even just $25 each month can knock a few years off your loan.
- Make one extra payment each year – If you have a certain time of year that you make more money (bonus or commission), you may pay one extra mortgage payment each year. This has a similar effect of paying extra money each month; you just pay it in one lump sum.
- Pay 1/12th of the mortgage payment in addition to your mortgage payment –If you take your principal and interest payment and divide it equally into 12 payments throughout the year, you’ll make one extra payment each year.
The Downside of Making Extra Principal Payments
While making extra principal payments sounds great, there definitely are some downsides.
- You lose liquidity – Funds tied up in your home aren’t liquid. You would have to refinance in order to get access to the funds. This could take between four and six weeks to get done. If you need the money fast, this could be an issue.
- You may lose money – Depending on the state of the economy and the market, there may be better places to invest your money, such as stocks, bonds, or money market funds. This is called opportunity cost, which may affect your financial position when you retire.
Things to Consider Before Prepaying Your Mortgage
Before you decide to put extra money towards your mortgage balance, consider the following questions:
- Do you have an emergency fund set aside? In other words, if your hot water heater broke or you had a dental emergency, would you have the funds to pay for it? If not, you may want to consider creating an emergency fund with at least six months of income in it before paying extra towards your mortgage.
- Do you have retirement funds? Are you set up for your future? This is especially important if you have a 401K where your employer matches your contributions. You can’t predict the value of your home when you retire, so you won’t know how much money you’ll get if you sell your home. Having a retirement fund ready is a much better option.
- Do you have credit card debt? You are probably paying much more in interest on your credit card debt than you would save by paying your mortgage early. Get yourself out of credit card debt before you make extra payments towards your principal.
Paying extra principal on your mortgage can be a great thing if you are in the right financial situation. It’s not the right choice for everyone. Take a long, hard look at your financial position to decide if you are in the right position to do so. Even though paying extra towards the principal has the greatest effect during the first few years of your mortgage, you can start this habit at any point during the life of your loan.