Paying extra on your mortgage can be a good idea. It can shave years off your home loan and save tens of thousands of dollars in interest charges.
The one thing you should not do, however, is sign up for an accelerated payment plan from a mortgage service company that costs hundreds of dollars. There are better ways to cut that home loan down to size.
Here are three free and easy options, and one that isn’t free but can still save you tons of money.
1. Increase your monthly checks by one-twelfth.
The additional money you’re sending reduces the balance of your principal, which is the actual amount you owe on the house without interest. The biggest share of your early mortgage payments goes to paying interest, so paying a little extra on principal now makes a huge difference in the years ahead.
2. Make one extra payment a year.
This works especially well if you get an annual bonus or always receive a sizable income tax refund. Just add the money to your next monthly payment.
Once again, you’re chopping away at that principal ahead of schedule.
3. Pay half of your regular monthly payment every two weeks.
Although a few lenders allow customers to switch to biweekly payments at no charge, most won’t do that, nor will they accept partial payments.
But you can have the money automatically transferred from your checking account to a savings account every two weeks and then transferred to your lender at the end of every month. Ask your bank or credit union for help setting up online transactions, if necessary.
By the end of the year, you’ll have made 26 half payments, which adds up to 13 full payments — or, again, one full extra payment.
Caution: Paying down the principal on your home loan more quickly will never reduce the minimum monthly payment or allow you to skip a payment. It simply shortens the length of the loan and reduces the total amount of interest you have to pay.
How much could you save?
Extra payments add up!
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A $200,000 30-year home loan with an interest rate of 5% would cost $186,512 in interest with the traditional 12 payments a year. Make the equivalent of 13 monthly payments every year, and the loan will be retired in 26 years and you will pay only $153,813 in interest — a savings of $32,699.
Of course, you don’t have to keep your home loan for decades to benefit from extra payments.
You’ll immediately begin adding to your equity (the difference between what your home is worth and how much you owe on your loan). That lets you ditch private mortgage insurance sooner, saving you as much as a couple hundred dollars a month.
If you ever have an emergency, you’ll have more equity to take out a home equity loan. And, of course, the less you owe on your mortgage, the more money you pocket if you sell your home. The biggest challenge to following through with a faster payoff plan is maintaining self-discipline. It’s easy to start paying extra — until you have extra expenses or you forget an extra payment.
That’s where mortgage service companies say they can help. When you buy an accelerated biweekly payment plan from one, you’re essentially asking the company to make you pay off your loan early. They collect your biweekly checks and fine you if you miss one of your voluntary payments.
According to them, the threat of those penalties and the hundreds of dollars they charge in setup and maintenance fees are worth it to save tens of thousands of dollars in the long run.
But they’re not.
Start-up fees begin at $300, and many service companies also charge processing fees of anywhere from $2.50 to $10, plus monthly or annual maintenance fees.
Some service companies pay interest on the money they’re holding, but that won’t come close to covering the fees.
The U.S. Consumer Financial Protection Bureau sued one company, Ohio-based Nationwide Biweekly Administration, in 2015, accusing it of misleading consumers about the potential savings from its plans.
Nationwide was charging a start-up fee of $995, plus yearly administrative costs of up to $101. The protection bureau noted that someone who signed up for the plan with a 30-year mortgage of $160,000 at 4.5% would have to stay in the program for nine years to recoup their fees. (Nationwide suspended operations after the suit was filed.)
Even if you only pay a $300 initial fee and then $10 a month, you’ll spend $420 in the first year and $2,700 over 20 years. If you don’t make all 26 payments a year on time, you’ll have late fees added to that and wind up paying even more. That’s the kind of help you don’t need.
This brings us to the option that isn’t free but can potentially save the most money. If you really want to discipline yourself to pay off your home loan sooner, consider refinancing for a shorter time period. Most fixed-rate mortgages are 30 years, but you can get loans that last 20, 15 or even just 10 years.
Loans that run for shorter periods generally come with lower interest rates. The combination of a lower rate and less time can really add up.
Let’s look at that $200,000 mortgage again, this time for only 15 years. A 15-year loan runs about one percentage point cheaper than a 30-year loan. With a 15-year mortgage at 4%, you’d pay about $66,288 in interest over the life of the loan. That’s a savings of more than $120,000 in interest over a 30-year loan at 5%.
Of course, your monthly principal and interest payments would go up significantly, from around $1,074 to $1,479, so you would need to make absolutely sure you could handle that increase. You’d also have to pay some loan closing costs, although most usually can be wrapped into your loan.
But if you’re positive you can swing it, shortening the time of your mortgage can be the shortcut to huge savings — even the day you own your home free and clear.
By: Reed Karaim, September 4, 2018