Speed up your mortgage paydown! What you need to know about prepayment

What you need to know about prepayment privileges

When you’re shopping for a mortgage, one of the things you need to check out is your options relating to prepayment privileges.  These are the bells and whistles on your mortgage that you might pay little attention to, when getting your mortgage.

The ability to make payments in addition to your scheduled payment

This enables you to speed up your mortgage paydown, and reduce the interest you pay to your lender significantly.  But not all lenders offer you the same options when it comes to paying early.

Prepayment privileges differ from lender to lender

Most lenders allow you to make “lump sum” payments of 15% or 20% of the mortgage amount.  Some restrict you to make the lump sum payment once a year; others allow you flexibility to make extra lump sum payments of as little as $100 whenever you like, as long as the cumulative total throughout the year is not more than the maximum percentage.

In addition, usually lenders will also allow you to increase your regular payments by 15% or 20% of your original payment amount, per year.

Some even throw in fancy options like the option to “double up” a payment, which allows you to double your regular payment whenever you like.

If you take advantage to some or all of these, you can really speed up the paydown of your mortgage and save tons of interest!

Let’s look at an example

Take the so-called “20 + 20” privilege; it allows an annual mortgage payment increase of up to 20% of the current payment, and a lump sum payment of up to 20%, per year, of the original amount you borrowed.

Example: $200,000 mortgage amortized for 25 years at 3.5%.

If you put a $2,000 lump sum each year – that’s only 1% of your mortgage amount, by the way – toward your mortgage, you’ll pay that mortgage off in 20 years, instead of 25.  And, you will save $21,726 in interest.  Or, increase your monthly payment by $200, and you’ll pay off your mortgage in 19 years and save $23,937 in interest.

If you can do both, all the better; you’ll save more and pay your mortgage off even faster.

What about decreasing your amortization?

I’ve had clients tell me they want to pay down their mortgage as quickly as humanly possible, and they want to max out the monthly payments and decrease the amortization – the length of time that it takes to pay down your mortgage to zero – to the shortest period of time they can.  This can be good, but here’s the challenge with this.  Using the amounts in the example above, let’s say you want to pay off the $200,000 mortgage in 15 years rather than 25.   With a 25 year amortization, your payment would be approximately $999.  Taking a 15 year amortization means you’re committed to a monthly payment of $1,427, an increase of $428 per month.  That translates into paying an extra $5,136 per year, and a savings of $42,649 in interest.  Sounds great, right?

The catch: life happens.  I’ve had clients who did arrange with their mortgage lender to decrease their amortization upon renewal. But then a big expense cropped up, or job issues surfaced, and they suddenly had additional credit line and credit card payments they had to make.  Since mortgage interest rates are much lower than those on credit cards or even credit lines, it would make sense to focus on paying the higher interest debts as quickly as possible.  But, because of the larger mortgage payments they were committed to, they were too cash-strapped to be able to make much more than the minimum payments on the credit cards.  It set up a very stressful cycle that they weren’t able to break free from.

So what’s the alternative?   Stick with the longer amortization on your contract, but make extra payments of the amount that you would have paid.  So in this case, pay that $5,136 per year (or more!) and put it against the mortgage each year.  Effectively, your amortization will still be 15 years.  But, this strategy leaves you with flexibility if you need it.

Where can you find money for your mortgage paydown?

How about your tax refund or bonuses from work? If your income increases, consider increasing your mortgage payment, or putting the increased amount into a separate savings account that you draw from (once a year, or more frequently, depending on the options available to you with your specific lender), to make lump sum payments onto your mortgage.  Pretend your income didn’t increase and maintain your usual lifestyle.

Let me know what your experience has been with mortgage prepayment options.  If you’d like to see more, take a look through some of my other blog posts and let me know what you think!

Happy homebuying…