In recent years, many mortgages--especially adjustable rate mortgages (ARMs)--include "prepayment penalty" clauses. A true prepayment penalty strictly forbids sending in any additional money to retire your mortgage more quickly than originally contracted, without paying a cash penalty. Prepayment penalties are largely banned in most states, but enterprising underwriters unearthed a legal loophole that could cost you.
The majority of recent mortgage loans lack "prepayment penalty" clauses, per se; rather, they are structured as "anti-refinancing" clauses, which don't prevent sending additional money, but apply only to total or partial repayments which are in excess of a given percentage (usually 20% or more of the outstanding balance), typically during the early years of your mortgage term. If you have a recent loan and plan to prepay, you should check the terms of your contract. If need be, adjust your mortgage prepayments to a level that doesn’t trigger a penalty now, and add more to your later payments.
Take time to decide on exactly how you plan on prepaying your mortgage and define the timeframe in which you hope to pay off your mortgage. The greatest prepayment benefits come when starting early in your loan term; different mortgage prepayment methods can create different outcomes and savings, but most important is to make a commitment you can stick with over the long haul. Even small, painless prepayments can have tremendous cumulative effect... but you need to commit to making them month after month to really achieve results.
Prepaying mortgage regularly vs. occasionally
Once you're in a position to prepay your mortgage, decide exactly how to do it. There are five common prepayment methods:
- Regular, fixed monthly applications of additional principal
- Rounding monthly payments
- Automatic bi-weekly payments
- 13th monthly payment
- Large lump-sum prepayment
Making irregular prepayments — as funds permit — can also help you pay down your mortgage (this complicates accounting, but can save some money overall.)
If you’ve considered Refinancing instead of prepaying your mortgage and determined that prepaying makes the most sense for you, review our next article detailing various mortgage prepayment methods.