You've managed to save a little extra cash, received a bonus or raise, or gained an inheritance. Whatever the case, you're now faced with figuring out how best to use your new money.
Most people start by considering how they can add to their financial security by paying down an existing bill, such as a mortgage. Although it is generally prudent not to splurge, it's important to factor in several elements before deciding to use your extra cash to pay down a mortgage. For example, could that extra cash be better used to earn more through an investment? You also need to know whether you'll actually benefit financially from prepaying your mortgage, which requires running the numbers.
Borrowers with a fixed-rate mortgage can reduce the principal and therefore lower total interest paid over the life of the loan by paying a little extra each month. Take someone with a $150,000 loan at 6.5% interest over 30 years as an example. If this homeowner paid an extra $100 each month, they would save almost $52,000 in interest and pay the loan off nearly seven years early. Doubling the extra payment to $200 would raise the saved interest to about $80,000 and shorten the loan by roughly 11 years.
Those numbers are tempting, but they don't reflect the tax advantage of carrying a mortgage. Paying less interest and finishing the loan earlier also means losing years of mortgage interest tax deductions. To figure actual savings from prepaying, compare your mortgage interest rate with the after-tax benefit of keeping the deduction. For example, someone in the 28% tax bracket with a 6.5% mortgage has a post-tax cost of about 4.68%. An investment that reliably earns more than 4.68% after taxes would likely be a better financial choice than prepaying the mortgage.
The same logic applies if your mortgage rate is high or you can earn a higher return elsewhere. If your mortgage rate is 6% but you can earn 8% in an interest-bearing account or other investments, placing the extra cash where it earns 8% is generally the more advantageous decision.
If you've run the numbers and decide prepaying is right for you, keep your formal payment amount the same rather than changing it through the lender. That preserves payment flexibility. Contact the lender and instruct them to apply any additional payment to the principal, not toward the next scheduled payment. Also review your loan terms to confirm there is no prepayment penalty that would negate savings; a penalty of 3% on a $100,000 mortgage would subtract $3,000 from your gains. If you work with mortgage professionals, you can also review coverage options such as Mortgage Brokers/Bankers Insurance (E&O, General & Cyber) to understand related risks.
More often than not, there is no large financial gain from paying a mortgage off early; the primary benefit is emotional or psychological for those who want the mortgage burden removed. Weigh what the numbers tell you against your financial goals and personal peace of mind. If you're working with a broker or agent, consider resources like Real Estate & Mortgage Brokers Insurance when reviewing your overall situation.
Frequently Asked Questions
Will paying extra on my mortgage always save me money?
Not always; prepaying reduces interest but may cost you tax deductions and could be less profitable than investing the money elsewhere, depending on after-tax returns.
How do I ensure extra payments are applied to principal?
Contact your lender and explicitly instruct them to apply the additional amount to principal, and get confirmation of how the payment will be posted.
Should I worry about prepayment penalties?
Yes—check your loan terms for any prepayment penalty because it can offset interest savings from paying off the loan early.