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PREPAYMENT AND BIWEEKLY
MORTGAGE PAYMENTS
Introduction
Most homeowners make their regular mortgage payments every month for the duration of the loan term, and never think of doing otherwise. But prepaying your mortgage or making biweekly payments can reduce the amount of interest you'll pay over time.
How prepayment affects a mortgage
By prepaying your mortgage, you reduce the amount of interest you'll pay over the life of the loan, regardless of the type of mortgage. However, prepayment affects fixed rate mortgages and adjustable rate mortgages in different ways.
If you prepay a fixed rate mortgage, you'll pay your loan off early. By reducing the term of your mortgage, you'll pay less interest over the life of the loan, and you'll own your home free and clear in less time.
If you prepay an adjustable rate mortgage, the term of your mortgage generally won't change. Your total loan balance will be reduced faster than scheduled, so you'll pay less interest over the life of the loan. Every time your interest rate is recalculated, your monthly payments may go down as well, since they'll be calculated against a smaller principal balance. If your interest rate goes up substantially, however, your monthly payments could increase, even though your principal balance has decreased.
Should you prepay your mortgage?
If you have extra cash, should you invest it or use it to prepay your mortgage? You'll need to consider many factors when making your decision. For instance, do you have an investment alternative that will give you a greater yield after taxes than prepaying your mortgage would offer in savings? Perhaps you'd be better off putting your money in a tax-deferred investment vehicle (particularly one where your contributions are matched, as in some employer-sponsored 401(k) plans). Remember, though, that the interest savings you'll obtain by prepaying your mortgage is a certainty; by comparison, the return on an alternative investment may not be a sure thing.
Other factors may also influence your decision. The best time to consider making prepayments on your mortgage would be when:
- You can afford to contribute money on a regular basis
- You have no better investment alternatives of comparable certainty
- You cannot refinance your mortgage to obtain a lower interest rate
- You have no outstanding consumer debts that are charging you high interest that isn't deductible for income tax purposes (e.g., credit card balances)
- You are in the early years of your mortgage, when, given the amortization schedule, the interest charges are highest
- You have sufficient liquid savings (three to six months' worth of living expenses) to cover your needs in the event of an emergency
- You won't need the funds you'll use for mortgage prepayment in the near future for some other purpose, such as paying for college or caring for an aging parent
- You intend to remain in your home for at least the next few years
Can you prepay your mortgage without penalty?
You should find out whether your lender charges a penalty for mortgage prepayment. Any penalty charges would of course undercut your prepayment savings, and the penalties can sometimes be substantial.
Some lenders don't charge any prepayment penalties on their mortgages, while others may penalize you only if your prepayment exceeds a certain amount or occurs within a certain time period. In these instances, you may still be able to make prepayments without incurring a penalty if you're careful.
- Example(s): Your mortgage contract charges a penalty of 3 percent of the prepaid amount if you prepay 20 percent of the principal balance within the first two years. You can, however, prepay 15 percent of the balance in two years, save considerably on the interest charges, and incur no penalty for doing so.
Generally, Federal Housing Administration (FHA) and Department of Veterans Affairs (VA) loans can be prepaid without penalty. Check your loan documents or contact your lender to find out if a prepayment penalty applies to your loan.
Particularly against a fixed rate mortgage, regular contributions toward prepayment can dramatically shorten the life of the loan and result in substantial savings on the total interest you're charged.
- Example(s): If you pay off a $300,000 mortgage at 8 percent over 30 years, your normal payments against principal and interest will be $2,201 per month (rounded to whole dollars). You'll pay a total of about $492,466 in interest charges over the term of the loan. However, if you can pay an extra $200 every month, your mortgage will be paid off in just under 22½ years, and you'll save almost $146,000 in total interest charges.
Tip: Prepaying part of your mortgage doesn't change your monthly obligation to your lender. Regardless of how much you prepay, you'll be in default if you fail to make your minimum monthly payments. So, before you consider prepayment, it's important to establish an adequate emergency fund to carry you through unforeseen financial difficulties.
Biweekly payment schedules
A biweekly payment schedule is actually a formal method of mortgage prepayment. With a biweekly schedule, you make a payment on your mortgage every two weeks. Each payment is roughly equal to one-half of your normal monthly payment. If you maintain the schedule, you'll make an extra month's payment over the course of each year (26 half payments equal 13 full payments). You'll also pay less interest because your payments are applied to your principal balance more frequently.
- Example(s): Assume you have an 8 percent, 30-year mortgage of $300,000. Your normal monthly payment is $2,201 (rounded to whole dollars). Over the 30-year term, you'll pay about $492,466 in total interest. But if you arrange a biweekly payment schedule for this mortgage, with a biweekly payment amount of $1,100, you'd pay off the mortgage in approximately 23 years and save about $138,186 in total interest charges.
If you want to make biweekly mortgage payments, talk to your lender. The best time to do this is when you take out the mortgage. Find out if you will be charged a fee for this service, and ask if there's a penalty for dropping out of the program prematurely. You may at some point discover that you can't afford the extra payment or can't stick to the biweekly schedule.
Keep in mind that lender processing errors are more likely to occur with a biweekly payment schedule, since the lender receives twice as many payments on your mortgage. Moreover, given that the biweekly payment schedule may not always synchronize with your monthly mortgage due dates, your chances of making a late payment (and thus incurring a late fee and possibly blemishing your credit history) also increase with this alternative.
- Caution: Be cautious of biweekly payment plans set up by someone other than your lender (e.g., third-party arrangements).
It all adds up if you can do it on your own
By making your regular monthly mortgage payments and adding extra funds to each payment, you may achieve the same result on your own as you can with a biweekly payment schedule.
Here, the choice to prepay is yours each month. If you can contribute the extra amount on a regular basis, you'll reap the rewards. However, if you can't always pay the extra, you won't jeopardize your mortgage (and your credit report) as long as you can send in your regular monthly payment. This flexibility may be valuable if you encounter a period of financial difficulty.
