Putting a little extra cash toward your mortgage is a great money saver. These prepayments go directly toward paying down the principal of your loan. As a result, your loan is paid off faster and you end up saving a lot on interest payments.
But bear in mind that any extra payments you make to your mortgage lender get locked up in your home’s equity. Before you decide to pay an extra $100 a month toward your payment, make sure there are no better uses for your money, from long-term investments to paying down high-interest debt.
Prepayment SavingsTo figure out whether prepaying is the right choice for you, calculate the interest savings from prepaying your mortgage. To figure those savings, enter your mortgage information -- including the loan amount, interest rate and term of the loan -- into manybanking.com’s online mortgage calculator.
Say you borrowed $200,000 via a 30-year fixed-rate mortgage at a 6% interest rate. (These days, mortgage rates have come down considerably. manybanking.com's mortgage site shows mortgages from Wells Fargo at 5.125% and Citibank at 4.5%.) Your monthly principal and interest payments are $1,199, and over the life of your loan you'll end up paying $231,677 in interest. If you prepay your mortgage by $100 a month, you'll save a total of $49,139 and pay off your loan in less than 25 years.
By clicking on the View Report button of the calculator, you'll see how the prepayments affect your equity in your home. Say you decide to sell your home after 10 years. Without prepayments, you'll end up owing $167,371 on the remainder of your $200,000 mortgage. If you prepaid the $100 a month, however, you'd only end up owing $150,983. That's a $16,387 increase in home equity from a $100-per-month investment over 10 years (or a $12,000 investment).
Investment AlternativesNext, consider your return if you invested $100 a month instead of prepaying your mortgage. Using manybanking.com's Savings Calculator, enter $0 for the starting balance, 10 years for the duration and $100 for monthly contributions. This calculator compares multiple rates at the same time.
Let's say you find a money market account (MMA) that pays 1% interest on your deposits -- you’d have $12,623 after 10 years. (Check out manybanking.com to find offers like the 1.5% MMA offered by Bank of Utica or the 0.35% MMA offered by TD Bank’s TD Banknorth.) If you invested that $100 a month in the stock market, you’d have $18,128 after 10 years, assuming an average annual return of 8%.
In this case, prepaying your mortgage would result in $3,765 more in savings than putting the money in a low-yielding money market account. However, investing in the stock market at 8% provides the highest return of all three options. The problem, of course, is that it's difficult to accurately predict the direction of the stock market. So far this year, the Dow Jones Industrial Average is down about 33% and the S&P 500 has lost about 38% of its value.
For the risk-averse investor, the roughly 6% return from prepaying your mortgage may be attractive enough.
Considering Cash FlowIf you’re considering adding prepayments to your monthly mortgage bill, make sure those extra payments won’t stress your bank account. Also, consider whether that money could be better spent paying down high-interest debt or building up a cash cushion to deal with unexpected costs like a new roof or car repairs. Once you've answered those questions, the decision to prepay your mortgage is just a question of crunching the numbers.
Peter McDougall is a freelance writer who lives in Freeport, Maine, with his wife and their dog.