Thursday, February 17, 2011

How And Why To Prepay Your Mortgage

There is always ongoing discussion on whether or not it makes sense to completely payoff your home and own it free and clear. Peter Miller in the Realty Times did a survey on this matter a few years ago.

One of the best ways to have more cash, retire early, and enjoy a debt-free living is to prepay your mortgage, an option which even lenders increasingly applaud. But for financial reasons and as a matter of personal preference, many people favor a home with less debt. Why wait 30 years to be mortgage free, they reason, when the same goal can be accomplished years earlier without refinancing or new closing costs.

Understanding Prepayment Penalties:

If prepaying a loan seems attractive, the first question to ask is whether prepayments are permitted without penalty. Some loans punish borrowers for the crime of debt reduction by insisting on a penalty if some or all of the loan is paid in advance.

The good news about prepayment penalties is that they seem less frequent and less harsh than in the past. In some cases today, penalties expire after several years. With other loans, prepayment only kick-in after a certain point say when there has been an annual loan reduction of more than 20 percent.

In some cases there are loans which lack penalties but have specialized prepayment rules. For instance, under the FHA program if a prepayment is made after the monthly payment due date it will not be credited to the account until the next month. In essence, the borrower could lose the benefit of a prepayment for as much as several weeks.

In practice what you’re likely to find now is that lenders want your money as soon as possible. Extra money from penalties are of less priority to lender portfolios which become more secure when borrowers owe less.

Paying off the Debt:

You don’t have to prepay much to significantly reduce loan payoff times. For example, suppose you have a @200,000 mortgage at 8 percent interest, pay $1467.53 for principal and interest and the loan will be repaid in 30 years, pay an additional $100 a month and the debt will be retired six months earlier. Pay $200 a month extra and you can be out in a little more than 20 years.

At this point someone will wonder whether $100 might be better spent in the stock market. There’s no sure answer here because we don’t know how stocks or commodities will be valued in the future. What we do know is that by reducing the mortgage we are effectively cutting debt that must ultimately be repaid.

Does prepaying a home mortgage always make the most financial sense?

Because the interest cost for credit cards is typically higher than home loans, and because credit card interest is not tax deductible, if one must choose either one or the other, then reducing credit card debt is likely a better plan than accelerated mortgage payoffs- as long as credit card balances fall over time.

Of course, there’s no rule which says homeowners can’t prepay loans, pay down other debts and shift a few dollars into the stock market.

What about taxes? If a home mortgage is prepaid, interest deductions decline but this is hardly a problem. Which would you rather pay; $1 in interest or perhaps 31 cents in taxes? In both cases money leaves your pocket. The catch is that in one case more money leaves.

Another loan reduction concept is to make bi-weekly payments. Twenty-six bi-weekly payments are equivalent of 13 monthly payments. Since there are only 12 months in a year, bi-weekly payments are simply a way to pay lenders more and thus shorten loan terms. Some lenders will set up bi-weekly payment plans for you, typically in exchange for the rights to collect automatically from a checking account.

Prepayment rules for individual loans and specific lenders vary. For details, contact your lender, ask how your loan can be prepaid, and get answers in writing. Some lenders have monthly forms which automatically allow for prepayments while others have more exotic and complex prepayment programs. Whatever the lender’s preferences, always track your loan with care to assure that all extra payments are carefully credited to principal reductions.

For Buying or Selling, You Need a Guide that gives you straight answers. For more information on buying, selling, or renting out an income property in San Diego, please call Frank Rashid's cell phone at (858) 676-5250 or email him at More to follow within the next couple of weeks.