How And Why To Prepay Your Mortgage

One of the best ways to have more cash, retire early, and enjoy debt-free living is to prepay your mortgage, an option which even lenders increasingly applaud.

We live in a society where home debt is generally mounting. The Consumer Federation of America reported this month that between 1989 and 1999 home equity declined by $1,500, in part because of a greater willingness to increase mortgage debt. But for financial reasons and as a matter of personal preference, many people favor a home with less debt. Why wait 30 years to be mortgage-free, they reason, when the same goal can be accomplished years earlier without refinancing or new closing costs.

If prepaying a loan seems attractive, the first question to ask is whether prepayments are permitted without penalty. Some loans punish borrowers for the crime of debt reduction by insisting on a penalty if some or all of the loan is paid in advance.

The good news regarding prepayment penalties is that they seem less frequent and less harsh than in the past. In some cases today, penalties expire after several years. With other loans, prepayment penalties only kick-in after a certain point, say when there has been an annual loan reduction of more than 20 percent.

In some cases there are loans which lack penalties but have specialized prepayment rules. For instance, under the FHA program if a prepayment is made after the monthly payment due date it will not be credited to the account until the next month. In essence, the borrower could lose the benefit of a prepayment for as much as several weeks. In practice what you're likely to find now is that lenders want your money as soon as possible. Forget penalties, say lenders, write bigger checks.

The change of heart (yes, lenders have hearts) relates to a new view of risk. It's nice to get extra money from penalties, but lender portfolios are more secure when borrowers owe less.

You don't have to prepay much to significantly reduce loan payoff times. For example, suppose you have a $200,000 mortgage at 8 percent interest. Pay $1,467.53 for principal and interest and the loan will be repaid in 30 years. Pay an additional $100 a month and the debt will be retired six years early. Pay $200 a month extra and you can be out in a little more than 20 years.

At this point someone will wonder whether $100 might be better spent in the stock market or with the purchase of pork bellies. There's no sure answer here because we don't know how stocks or commodities will be valued in the future. We DO know that by reducing the mortgage we are effectively cutting debt that must ultimately be repaid.

Does prepaying a home mortgage always make the most financial sense? Because the interest cost for credit cards is typically higher than home loans, and because credit card interest is not tax deductible, if one must choose either one or the other, then reducing credit card debt is likely a better plan than accelerated mortgage payoffs -- as long as credit card balances fall over time.

If the question concerns auto loans, the answer is different: Their interest is usually front-loaded so prepayments may not result in significant gains.

Of course, there's no rule which says homeowners can't prepay loans, pay-down other debts, or shift a few dollars into the stock market.

What about taxes? If a home mortgage is prepaid, interest deductions decline but this is hardly a problem. Which would you rather pay: $1 in interest or perhaps 31¢ in taxes? In both cases money leaves your pocket. The catch is that in one case more money leaves.

Okay, why pay off a mortgage early since people routinely move or refinance after 8 to 12 years? Because when you move or refinance you'll owe less to the original lender; seen another way you'll walk away from closing with a bigger check.

Another loan reduction concept is to make bi-weekly payments. Twenty-six bi-weekly payments are the equivalent of 13 monthly payments. Since there are only 12 months in a year, bi-weekly payments are simply a way to pay lenders more and thus shorten loan terms. Some lenders will set up bi-weekly payment plans for you, typically in exchange for the right to collect automatically from a checking account.

(As to those e-mails offering to collect your mortgage dollars on a bi-weekly basis, forget it. Payments to anyone but your lender should be avoided.) Lastly, if that dot.com stock really paid off, think about a curtailment. A full curtailment means you pay-off the remaining loan balance, while a partial curtailment means repaying a big chunk of your debt.

Prepayment rules for individual loans and specific lenders vary. For details, contact your lender, ask how your loan can be prepaid, and get answers in writing. Some lenders have monthly forms which automatically allow for prepayments while others have more exotic and complex prepayment programs. Whatever the lender's preferences, always track your loan with care to assure that all extra payments are fully credited to principal reductions.

In the case of a curtailment, before making a lump-sum payment obtain instructions in writing from the lender. If big money is involved, or if the loan is being paid off, get assistance from a real estate attorney.

Written by Peter G. Miller