Cut Your Mortgage Down to Size

 

You can pay your mortgage off early and save thousands.
 

Any time you pay the bank interest you end up “giving away” some of your hard-earned cash.  This is true whether you are talking about a credit card purchase or a home loan.  Maybe you’ve never thought of interest as money you’re giving away, but the bottom line is you no longer hold that money and that means you give up the choice to spend it on other things you may want or need now, or to save it for some future purpose.  This is why it’s so critical to take whatever steps you can to reduce or eliminate debt—the interest you pay slowly eats away at your ability to accumulate wealth.

 

As you may know, by refinancing your mortgage to a lower interest rate you can cut your monthly payments, and that saves a huge amount of money over the long haul.  What you might not realize is that there is another strategy that is equally powerful. By paying just a little extra on your mortgage each month, you can pay off your home many years sooner and save tens of thousands of dollars over the life of your loan. Taking either one of these steps can mean big savings. Combine both steps together and it could mean the difference in making sure you can afford to keep your home in retirement.

 

Are You Paying Double for Your Home?

 

Remember when you first started looking at houses and your Realtor asked you how much you were willing to pay?  If you’re like most buyers, you probably put in an offer on a home at a certain price, negotiated with the seller, and then arrived at a figure that was somewhere in the ball park.  Maybe you think you got a terrific deal if the purchase price ended up at $299,500.   Would you think the same thing if someone told you the actual amount you’ll end up paying is $600,000 or more?

 

Mortgage lenders make buying a home possible, but there’s one particular aspect of the process they probably hope you won’t spend a whole lot of time thinking about.  Know what it is?  When you buy a home for your family you’ll end up spending so much extra on interest that by the time you’re done paying it’s like buying a second home for the bank.

 

The Truth In Lending Statement tells you how much you'll actually pay.

For this mortgage, the cost of the loan more than doubles due to the interest.

Though lenders are required to disclose the total cost for a loan on a Truth In Lending Disclosure Statement, few people really bother to consider that the cost of interest can double or even triple their purchase price.  Sadly, this is true even at today’s historically low interest rates.

 

For example, suppose you take out a $100,000 mortgage with a standard 30 year term. Based on the interest rate you are paying, here is how much money it will take to pay off your home in the next 30 years, including both principal and interest:

 

The higher your interest the more you'll save.

 

If your mortgage is a different size, you can adjust these numbers accordingly. For example, if you have a $200,000 loan at 5.5%, the total dollars you will eventually pay are twice what they are for a $100,000 loan, or 2 x $204,403 = $408,806.

 

The Benefits of Refinancing to Get a Lower Rate

 

If you’ve taken out a mortgage or refinanced lately, you may already have a low interest rate. If so, great! If you haven’t done it yet, it is a step well worth considering. The rates of 6%, or even 5% or less that we have seen in recent years represent historic lows and excellent savings for homeowners. As the table above shows, even though you will be paying double for your home at these rates, that is far better than paying nearly triple, as most homeowners did not so long ago.

 

Therefore, if you are still paying a high interest rate, you may be able to slash your monthly payment and total costs substantially by refinancing your mortgage.

 

Now, if you go back and look closer at the table above, you can see that for a $100,000 loan, lowering the rate from 6.5% to 5% will lower the total dollars you will pay from $227,543 to $193,257. This is a savings of $34,286 over the 30 year life of the loan. By the way, this will also lower your basic payment (principal and interest) from $632.07 to $536.82, for a savings of nearly $100 a month.

 

Taking the Next Step to Save Even More

 

Not everyone will qualify to refinance under the new more stringent mortgage guidelines.  For some, the added costs of redoing their mortgage or the requirement to take on “mortgage insurance payments” may not make it worthwhile.  Others may fail to qualify if the market value of their home is less than or just about equal to the outstanding balance on their existing mortgage.  In either case, be aware there is another alternative to saving a significant amount of money as you pay off your home loan.  How?  Simply pay a little extra on the loan every month. It can be any amount.  Just pay whatever you can afford on a regular basis.

 

This might not be as hard as you imagine. If you refinanced, the lower interest rate you received means your monthly mortgage payment went down. This gives you some slack to pay extra each month. If you haven’t refinanced, consider finding other ways to reduce your monthly expenses.  For dozens of ideas, just check out our “Great Savings Tips” series here. Once you come up with a plan for spending less, take some of the extra cash you generate and add it to your regular mortgage payment.  And don’t worry:  Paying extra does not undo the savings you gained if you were able to lower your interest rate through a refinance.  It just means you’ll be debt free sooner and that means you’ll end up with more wealth.

 

For example, suppose you could afford to pay $50 extra with each mortgage payment. If you have a 6% loan with payment of $600 per month, you might choose to pay $650 per month instead. If you do this, you will pay off your mortgage about 5.4 years sooner. This will also generate savings of about $24,500 by the time the loan is paid off. In other words, here are two great benefits from paying extra:

 

1) You will own your home free and clear much sooner

2) You will save many thousands of dollars

 

The Nuts and Bolts

 

Why is it so powerful to pay a little extra every month on your mortgage? Because once you have made your normal payment for the month, any extra money you pay is directly taken off of the loan balance. This means:

 

♦ You are making the loan smaller every month with your extra payment.

♦ No part of your extra payment is wasted by paying interest.

 

Think of it this way:  In the early years of your mortgage your regular monthly payment is almost all interest. For example, on a 30 year loan with 6% interest, the monthly payment is $599.55. Of this amount, $500 is pure interest—money you’re giving to the bank. At first, only $99.55 will be taken off of the loan balance. Over time the equation shifts.  As you pay off a little extra principal each month you gradually reduce the total balance of your loan.  That means each month you’ll pay a little less interest and a little more principal.  Unfortunately, it will take 18½ years before you reach the point where you’ll be paying more principal than interest.

 

There is only one potential pitfall that may get in the way of this savings plan.  If your loan is unusual and requires that you pay a penalty for paying off any portion of your principal early (i.e. a pre-payment penalty) then depending on the amount it may negate any savings.  Be sure to read the terms of your loan to find out whether or not this applies to you.  Most modern home loans won’t carry a pre-payment penalty, especially not for small amounts such as we are talking about here, but it is something you need to be aware of.

 

(Note: If you begin paying extra money to lower your loan balance, check the figures on your bill the following month to make sure all of your extra payment went to lowering the balance. If not, the bank has made an error and must correct it.)

 

The Savings You Can Expect by Paying Extra

 

How much bang for your buck do you get by paying a little extra money every month? Does even a small extra payment make a difference? Here is an example of the savings you can achieve for various sizes of extra payments.

 

Paying more on your mortgage every month saves big time.

 

For example, suppose you decide to pay $50 extra every month. This means instead of paying $599.55, you will be paying $649.55 per month. According to the table, your mortgage will be paid off 5 years and 5 months early, and you will end up paying $24,569 less over the life of your loan.

 

The last column of the table shows how much money you could earn if you invested the extra payment in a savings account at a rate of 2% instead of using it to pay down your mortgage. Does it make more sense to invest the extra money instead?  In this case, no—you achieve greater savings by using it to pay your mortgage. In this example, you would need to earn something like a 4% return on investment to do better elsewhere. However, it varies, and sometimes an investment will pay better than paying down your mortgage.

 

What if you could earn a much higher return on some other investment, for example in stocks or mutual funds? If you were assured of earning more than the interest rate charged on your mortgage, it might make sense to invest the money. However, using it to pay down your mortgage is more certain, and it has other benefits. You will own your home free and clear much sooner, and you may sleep better the next time the market takes a nosedive.

 

If you would like to experiment so see how a specific series of extra payments will effect your mortgage, Bankrate.com offers a free online calculator that may be worth checking out.  First, enter the mortgage amount, the term (e.g. 30 years), and the interest rate. Click the “Calculate” button. Next, look below where you may enter extra payment amounts. Enter the amount extra you will pay in the first box, and click the button, “Show/Recalculate Mortgage Table”. You will then see a month-by-month breakdown, showing how the loan balance grows smaller and how long it will take to be paid off.

 

Other Ways to Cut Mortgage Costs

 

There are other ways to achieve similar savings besides paying extra with each monthly payment. For example, you can refinance your 30 year loan into a 15 year loan, with a substantially lower interest rate. Fifteen year loans have cheaper rates, so this may save you money as long as you are sure you can afford the payments. However, this has two disadvantages. (1) When you refinance your mortgage you are typically charged a fee and that could negate a portion of your savings. (2) Once you’ve refinanced you end up with a higher monthly payment for the life of your loan. That can work if you have the income to support it, but can also be a trap if either you or your partner lose a job.  By using the strategy outlined above, you aren’t locked in to paying more if you’re hit by a sudden emergency requiring extra cash. Sometimes the best plans are those that offer the most flexibility.

 

Another way to achieve similar savings on a mortgage is to switch to a “biweekly” payment plan. This is often touted as a unique or nifty way to save, though there is really nothing special about it. By paying every two weeks instead of every month, you will end up making the equivalent 13 mortgage payments per year (i.e. 26 half payments), instead of 12 monthly payments. So this option is just like making one extra payment per year, except it is a special type of loan that you need to apply for with the bank. So here again, it may be inconvenient to set up, and it is inflexible once you start it. For more information on why biweekly mortgages are not all they’re cracked up to be, see this article.

 

Though there are many options, for most people the best plan is to simply decide how much extra you can pay each month, and then pay it. If you’ve set up automatic mortgage payments with your bank, you can pay a little extra each month in a painless way—one guaranteed to build a brighter future.

 

By refinancing to a lower rate, paying a little extra every month, or by combining both strategies, you can own your home free and clear home much sooner than you expected.  Now, that’s really something to look forward to!

 

 

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