You've managed to save a little extra cash, received a bonus or raise from work, or gained an inheritance. Whatever the case, you're now faced with figuring out how best to use your new cash.
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's a prudent decision not to use the money to splurge, it's still important to factor in several elements before deciding to use your extra cash to pay down a mortgage. For example, consider if that extra cash could be better used to earn even more money through a returnable investment? Another important element in your decision is whether or not you'll actually benefit financially from prepaying your mortgage. To know this you'll need to run some numbers.
Borrowers with a fixed-rate mortgage can decrease how much money they owe on the principal, which ultimately lowers the interest rate paid over the course 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 dollars each month, they would ultimately save almost $52,000 worth of interest over the course of the loan and pay the loan off almost seven years early. This scenario would increase to almost $80,000 worth of saved interest and paying the mortgage off 11 years early if the extra money is doubled to $200 dollars.
These numbers are indeed tempting, but what the numbers don't reflect is your tax advantage from carrying a mortgage. As you see above, you'll pay less in interest, but you also pay the mortgage off earlier. Therefore, you will lose several years worth of tax breaks that you would've normally received from carrying a mortgage (mortgage interest rate tax break). To figure your actual savings from paying off a mortgage early, you must figure the difference between the rate at which your deduction is taken and your mortgage interest rate. It might be that the amount profited from investing your extra cash is substantially more than the above net percentage figure. Take the above person paying an additional $100 toward their mortgage as an example. If this person is in the 28% tax bracket and has a 6.5% interest rate, then their post-tax return rate is 4.68%. An investment that earns more than a post-tax return rate of 4.68% would be more financially advantageous for this person.
The same logic can be applied if you have a mortgage interest rate that's high or rising substantially. For example, let's say your interest rate is 6%, but you can earn 8% from just placing the extra cash in an account that bears interest. The decision that would be most financially advantageous would be to go with the interest-bearing account.
You've run the numbers and determined that prepaying your mortgage is a financially sound decision or just feel that removing the financial burden early is worth it to you. It's best to keep your formal payment the same. You will forfeit your payment flexibility by officially changing the payment amount through the lender. Do contact the lender to inform them that the additional payment should be applied to the principle, not toward the next payment due. You should also review your loan terms to make sure there isn't a penalty for early payoff that would negate any of your savings. A penalty of just 3% on a $100,000 mortgage would deduct $3,000 from whatever you've saved through early payoff.
More often than not, there usually isn't any real financial gain from paying a mortgage off early. The real gain is for those who have an emotional or psychological need to remove the burden of a mortgage as soon as possible. You'll have to weigh what the numbers tell you against your financial goals and emotional needs to determine the value of paying your mortgage off early.