Should you prepay your mortgage? for some homeowners, it’s a financially savvy move but for others, beefing up their loan payments just doesn’t make sense. To help you figure out whether prepayment is right for you, here are the pros and cons.
Pro: You’ll Cut Down On The Interest You Owe
interest is the extra fee you pay your lender for loaning you the cash you needed to buy a home. After all, lenders don’t just hand out dough for free, they’re in the business to make money.
By increasing your monthly mortgage payments (also called “prepaying” your mortgage) you’ll effectively save money in interest charges. Those savings can add up big-time.
For example, let’s say you take out a $200,000 mortgage with a 4% fixed interest rate and a 30-year term. If you continue to make your minimum monthly payments, you’d be forking over $143,739 in interest over 30 years until the debt is paid off. But, by paying an extra $100 per month, you’d pay only $116,702 in interest over a 25-year time span, a savings of $27,037.
Pro: You’ll Get Your Mortgage Paid Off Sooner
By accelerating your mortgage payments, you’ll also be shortening how long it takes to pay off the loan, which would increase your cash flow in the future. That’s a huge incentive for some borrowers.
For families with young children, where the parents are concerned about paying for their children’s college tuition, sometimes it may be best to increase mortgage payments so when their kids head off to college their mortgage is paid for.
Paying more money each month toward your mortgage’s principal can also give you peace of mind. Emotionally, it’s gratifying knowing that you’re paying your mortgage sooner than you originally planned to do.
Pro: You’ll Build Equity Faster
No matter how much money you put down on your mortgage, your home equity is the current market value of your home minus the amount you owe on your loan. So say your home is worth $250,000 and your mortgage balance is $200,000. In this case, you’d have $50,000, or 20%, in home equity.
Making larger mortgage payments toward your loan’s principal would enable you to build equity faster. Having more home equity can be a tremendous boon if you’re looking to get a home equity loan or home equity line of credit, such as to pay for home improvements.
Pro: It Helps Your Credit Score
Showing that you have less debt and that you manage your debts responsibly, by paying your mortgage off early, can raise your credit score. That can help if you’re planning to apply for a car loan or a second mortgage on a vacation home since your credit score would affect the interest rate you qualify for.
Con: Prepaying Reduces Mortgage Interest, Which is Tax-Deductible
Because prepaying your mortgage reduces your mortgage interest, it may not make sense from a tax-savings perspective. Mortgages are structured so that you start off paying more interest than principal.
For example, in the first year of a $300,000, 30-year loan at a fixed 4% interest rate, you’d be deducting $10,920. Nonetheless, taking a mortgage interest deduction under the new tax law requires itemizing deductions and itemizing may no longer make sense for many homeowners, since the standard deduction jumped under the new tax plan to $12,200 for individuals, $18,350 for heads of household, and $24,400 for married couples filing jointly.
Con: You Could Miss Out On More Lucrative Investment Opportunities
Every dollar you put toward your mortgage principal is a dollar you can’t invest in higher-yield ventures, such as stocks, high-yield bonds, or real estate investment trusts. That being said, you’d be assuming more risk be investing your money in, say, the stock market instead of putting the money toward your mortgage. You have to consider your risk tolerance before you decide where to put your extra cash.
Con: You May Miss Paying Off Higher-Interest Debts
For many homeowners, paying off higher-interest debt (such as from a credit card or private student loan) is more important than prepaying their mortgage.
if you’re carrying a $400 debt on a credit card from month yo month with a 20% interest rate, the amount of money you’re paying in credit card interest is $80 per month. That would be leaps and bounds higher than what you’d be paying in mortgage interest on a home loan with a 4% interest rate.
Con: Prepaying a Mortgage Could Hamper Achieving Other Financial Goals
Building your retirement savings is crucial, of course. However, some people make the mistake of prepaying their mortgage instead of maxing out their retirement contributions. At the bare minimum, you should do a full 401(k) match with your employer.
Also, people should build a sufficient emergency fund. This is typically a fund large enough to cover three to six months of their essential expenses. Doing this before you focus on prepaying your mortgage is the best practice.
Con: There May Be Penalties For Prepaying Your Mortgage
Some lenders charge a fee if a client’s mortgage is paid in full before the loan term ends. That’s why it’s important to check with your mortgage lender or look for the term “prepayment disclosure” in your mortgage agreement.
The bottom line: If you don’t have enough money to pad your savings before you begin paying off your mortgage early, prepaying your home loan may put you in a financial hole if an emergency crops up.
Still not sure what direction to go in? Consider sitting down with a financial planner to discuss your options based on your personal finances.
