PRACTICAL SAVER: Pay a little more each month to get ahead on your mortgage
With 30 percent of our income spent on housing costs, it is an understatement to declare the significant impact mortgages have on our overall financial picture. In fact, according to StatisticBrain.com, 22 percent of borrowers owe more than their home is worth. Even though I do not work in the mortgage industry, as a financial planner, I enjoy crunching numbers and analyzing mortgage strategies. Below are a few tricks to help you climb out from under your mortgage quicker, as well as save thousands of dollars on interest in the process.
Prepaying a mortgage is when extra money is paid in addition to the required mortgage payment. Each time a prepayment of principle is made, the outstanding balance is reduced. This in turn lowers the accrued interest. When sending in the payment, however, it is important to designate that the prepayment portion of the payment be applied to the principle. If the payment is not labeled properly, the extra money will be applied to the interest instead of the principle, meaning the extra amount will be applied towards the next payment and not the principle.
Prior to beginning a mortgage prepayment plan, other consumer debt needs to be addressed. A standard mortgage can cost 4 to 8 percent per year in interest. Most credit card rates are significantly higher. If you have any credit card debt or automobile loans that are charging interest higher than your mortgage, those debts should be addressed first. Once those debts are eliminated, a mortgage prepayment plan can be considered.
Now let's look at how even small amounts can make a significant impact on mortgage prepayments. On a $100,000, 30-year loan that is being charged 3.66 percent interest rate, the total interest over the life of the loan would be $64,895 if no prepayment was made. If $40 was added each month over the life of the loan, the term would decrease from 30 years to 26 years, and the savings would be approximately $9,800 in interest.
Another prepayment option is paying the mortgage on a biweekly basis. This service is available through most lenders. A biweekly mortgage has half of the monthly payment paid every other week. The primary reason this aids in paying off a mortgage faster is that 13 monthly payments are made instead of 12. (There are 52 weeks in a year; 26 half payments made every other week is the same as 13 whole payments). These programs need to be established through the mortgage company. In years past, the enrollment and termination fees for these programs were high. Currently, the fees are much more manageable and usually consist of small monthly fee of $3 to $5.
To analyze the bi-weekly payment benefits, let's assume the same $100,000 loan at 3.66 percent for 30 years, with a $458 per month payment. For a bi-weekly program, the payment would be $229. The interest on a bi-weekly mortgage would be decreased to $54,900 ($9,995 savings), and the mortgage would be paid off in 25 years. The results are even more impressive if the interest rate is higher. At 5.3 percent, the interest savings on a bi-weekly plan would be closer to $21,000.
So, which prepayment option is better, $40 per month manual prepayment, or the automated bi-weekly payments? Surprisingly, the total interest savings over 30 years for the two options was very similar: $9,800 versus $9,995. The biweekly program slightly won the race on time by paying off one year faster. Each option has similar out-of-pocket prepayments: $480 per year for manual prepayment versus $506 per year for the bi-weekly. In summary, they are both viable options. Since the bi-weekly program is automated through the mortgage company, there is a better likelihood for homeowners to stay on track. In my opinion, it is also easier to budget smaller payments every two weeks versus larger ones once a month. Check with your lender to see how much a biweekly program would save you on your mortgage.
The world of mortgages can be confusing. Next week I will discuss when it is a good time to start mortgage prepayments, investigate other investment options, and evaluate the financial difference between a 15-year and a 30-year mortgage.
Kara Rozendaal, a financial planner, wife and homeschool mother of three, has lived in Prescott Valley for 16 years. Kara's website www.PracticalSaver.com helps make shopping simple and savings possible.
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