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Mortgage Prepayment Methods

Keith Gumbinger

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If you’ve decided to pay down or pay off your mortgage early by prepaying your loan, there are five common ways to achieve your goal.

    1. Regular monthly mortgage prepayments

      Regular monthly prepayments may be the best approach for most people. It might not save more money than certain other methods, but it can build a pattern of behavior that allows you to take small regular recurring bites out your mountain of mortgage debt.

      For example, let's say you have a $100,000 30-year fixed-rate mortgage with an interest rate of 4% that started just 12 months ago. You think you can start sending in an extra $50 per month on top of the scheduled $477.42 amount due, so you start this with the 13th payment. If you continue this until the loan comes to a conclusion, you'll have chopped almost 5 years off your original 30-year term -- and saved some $12,420 in interest costs. If you could cover an additional $100 per month from the same starting point about eight years would be trimmed from the term, with almost $21,000 in savings compared to not making prepayments at all.

      When you start the mortgage prepayment process matters. If you wait until you're five years into your loan to start sending another $50 per month, the savings diminish; instead of more than $12K in savings, you'll achieve just over $8,800 in savings and cut the total term by less than four years.

      Our mortgage amortization calculator easily handles regular mortgage prepayments.

      Expert tip: If you made a downpayment of less than 20% when you bought your home, your loan probably required private mortgage insurance (PMI). Through amortization, prepayment and property-price appreciation, you should be able to cancel that PMI policy at some point, perhaps as quickly as two years from when you bought your home. When you do get to a place where you can cancel PMI, you'll free up funds to prepay your mortgage every month, and all you have to do is keep your mortgage payment exactly the same as it was when PMI was required!

    2. Rounding monthly mortgage prepayments

      Maybe you don't feel like you can commit an extra $50 or $100 per month to your mortgage. After all, there are always plenty of things competing for a chunk of your budget each month.

      However, there is a method that can save you some money with just a simple checkbook trick: Rounding your monthly mortgage payment up to the next closest significant dollar increment.

      For example, if your payment is $477.42 per month, you simply round up the payment to the next nearest $10 increment ($480) -- a $2.58 per month prepayment.

      Before you laugh, consider this: Starting with the first payment on your mortgage, this small, incremental prepayment should trim three months off your mortgage term and save you over $850 in interest costs. Not a bad result for the flick of a pen!

      If you can make a bigger commitment, say, by rounding up your payment to an even $500 per month (a $22.58 per month prepayment) you can eliminate 29 months of future mortgage payments and keep almost $6,760 in interest savings to boot.

      How much might you save with this painless mortgage prepayment method? Try our RoundUp Mortgage Prepayment Calculator to find out.

      In addition to being pretty painless, one additional benefit of this small-dollar prepayment method is that it can be applied to virtually any other debts you might have, incrementally trimming interest costs as you go.

    3. Automatic bi-weekly mortgage prepayments

      A bi-weekly payment plan is another fairly painless way of making additional payments on your mortgage. While some mortgages are originated as true bi-weeklies, most start out as traditional 30-year terms, with a bi-weekly payment plan added later.

      In a bi-weekly arrangement, you are make a payment of principal and interest every two weeks, and each payment is half of what a normal monthly mortgage payment would be. Since there are 26 bi-weekly periods per year (52 weeks, divided by two) you're actually making the equivalent of thirteen monthly payments each year.

      Because mortgage servicers don't want to manage more than twice the volume of checks, the vast majority of bi-weekly payment plans are conducted using Electronic Fund Transfers (automatic deductions) from an account you specify. Every 14 days, the servicer accesses the account and draws the appropriate funds.

      While they work and are automatic, there are certain aspects of bi-weekly payment plans to consider:

      • First, you may be solicited by outside private firms who will "manage" your account for you – for a fee. Sometimes these are only one-time fees, but others have regular recurring charges which you'll want to avoid to maximize savings. Before retaining an outside firm, check with your existing lender or servicer to see if such a plan is available directly from them. If so, one can often be initiated with just a small one-time startup fee, typically no more than a few hundred dollars.

      • Second, be aware that you'll likely be required to fund that account with (and maintain) a pool of cash equivalent to two months' worth of payments, which could be a deterrent to joining up. Although you can sometimes select an interest-bearing account for the deposit, you must still amass the funds initially.

      There is no doubt that bi-weekly payment plans work, though. A 30-year mortgage, paid on a bi-weekly basis from day one, should be paid off in just under 23 years. Using an example loan of $100,000 at 4% interest, you could trim the term by almost 50 months and save over $11,000 in total interest cost.

      Track biweekly mortgage payment savings with our mortgage amortization calculator.

    4. 13th monthly payment

      If you don't have the cash available or desire to join a bi-weekly payment plan, you can obtain almost exactly the same interest and loan-term savings by simply sending in one extra monthly payment of principal and interest each year (a 13th monthly payment). Keep in mind, though, that this is not automatic, and you'll need the discipline to do it every year to achieve the same savings. If you get an annual bonus, tax refund or other lump-sum payment on an annual basis, you might consider this method instead of a biweekly plan.

      Rather than making half a payment every two weeks, sending an extra $477.42 as a lump-sum starting with the 12th monthly payment and doing it every 12 months thereafter will trim about 49 months off the original 360 month term, saving just under $11,000 in interest cost. The results are virtually identical to the savings and term reduction under a biweekly payment plan.

    5. Large lump-sum prepayment

      There’s always the option of sending a large amount of cash, such as an instant-lottery ticket payout or other windfall. This is likely to have a lesser effect the further along you are in your mortgage. The reason for this is that in the early years of your mortgage, payments largely comprise interest, and interest charges are high because your loan's principal amount remains high. By way of example, apply a $5,000 lump sum payment of principal to an 4%, $100,000 loan at the 13th payment; this simple one-time act has the effect of trimming some 32 months off the 30-year term, and saves you over $10,000 in interest cost. You just doubled your $5,000 windfall!

      However, that same $5,000 sent with the 39th monthly payment shortens the term by only about 30 months, with still-appreciable savings of over $8,800. Lump-sum prepaying early in your mortgage allows for long-term compounding of a lesser dollar amount, which translates into greater savings for you.

      This larger, lump sum arrangement might work well if you expect to get annual bonuses, or can even be a good way to use some (or even all) of any tax refunds you get every year (provided other financial areas of your life have been attended to, of course).

Creating a mortgage prepayment subsidy account

If you do have a lump sum available but hate to part with it, there is a way to hedge your bet and retain it as working or emergency capital, but still have the means to prepay your mortgage. Instead of sending a lump sum in to your mortgage in all at once, you instead can use it as a basis for a kind of "mortgage prepayment subsidy account."

In this method, you retain your original $5,000 but slowly chip away at it, using small pieces to fund regular monthly prepayments of your mortgage. For example, a $5,000 windfall translates into 200 $25 blocks, or 100 $50 blocks. As an example, and again starting from payment 12 of your 30-year loan, sending in an extra $25 per month from payment 12 to 211 would save you $6,265 in interest cost and trim the term to a total of 341 months; a $50 prepayment from payments 12 to 111 would reduce the term by 29 months and total interest costs by $8,404.

It bears considering that the smallest prepayment in our example -- $25 per month -- could be nearly self-perpetuating. At 3% simple interest, that $5,000 would return $150 over the next year, or about 6 "free" prepayments, and you'll still have your $5,000 liquid instead of locked up in your home. Find something with a 6% simple cash yield and you could have a $25 prepayment generated from that $5,000 for the life of your loan (alternately, a $10,000 windfall at 3% would achieve the same results). Of course, you could retain all $5,000 in an interest-bearing account and use the annual interest for "rounding up" your payment.

Prepay mortgage to shorten your loan term

You now know that prepaying can both save you money and shorten your loan term. However, you may not realize that you can actually determine the term of your loan by prepaying it.

Imagine you are reviewing future financial goals. You're 40 years old, just traded up to a new, bigger home, with a 30-year fixed rate mortgage. But, you're looking forward to retiring at age 63, and the prospect of having a mortgage to pay on a fixed income for seven years isn't in your budgetary plans.

Since it would be hard to find a lender offering a 23-year fixed rate loan, you can make one by prepaying. To find out how much additional money you'll need to send to meet your goal, use a prepayment calculator to determine what your monthly payment is now, and what it would be for a term of 23 years. The difference between the two becomes the amount of each month's prepayment, and you're on the road to a more comfortable retirement.

For example: a $100,000 loan amount, for 30 years at an interest rate of 4%, carries a monthly payment of $477.42, while the same loan amount and interest rate with a term of 23 years has a monthly payment of $554.76 -- and the difference between the two ($77.34) becomes your monthly prepayment amount to achieve that 23-year term. This method works for any term you desire. HSH's "It's My Term" prepayment calculator can help you do the math -- and see the savings.

If you read our previous article and reviewed your mortgage contract to avoid penalties, and have identified the best prepayment method for your circumstances, you can begin to consider what comes next when your mortgage is paid off.

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