Yes, you read that right. Making extra payments - while it doesn't sound like it - will help you save money on your mortgage costs.
Here's the logic, according to the Federal Reserve's mortgage refinancing guide: "By paying a little extra on principal each month, you will pay off the loan sooner and reduce the term of your loan."
So, can you see how extra payments now, can pay off later?
If it's hard for you to come up with some extra money each month, think of the disposable cash you are using for those fancy lattes or going out to dinner three times a week. It all adds up, Sebetka says, so you'll have to figure out what to sacrifice to come up with that extra cash.
Savings: $47,000. By making one extra payment of $1,199 each year and applying it to your principal, you could save over $47,000 in interest and cut 5 years off the life of the loan.
If you were to look at an amortization schedule for a 30-year fixed mortgage with a 5.3 percent interest rate, you would see that the payment total after 30 years is about twice the loan amount. Interest accounts for half of the total loan payments. Reducing the principal, then, would undoubtedly reduce some of the future interest payments as well. Before you start making those extra payments, however, there are several issues you would want to think about.
If you remain in the loan for its full term or most of the term and make extra payments on your mortgage, you will shorten the length of the loan and reduce its total cost. The higher the interest rate and the longer you stay in the loan, the more you will save. For example, if you have a 4 percent fixed interest rate on a $200,000 loan and make one $500 payment toward principal once a year, you will save a total of $12,190 in interest payments over the life of the loan and it would end just over 2 years earlier. If that same loan were at 6 percent, you would save $22,830 and the loan would end a full 2.5 years earlier.
The sooner you make extra principal payments, the more you save in interest. If instead of making an extra $500 payment once a year for 27 or 28 years you make just one principal payment of $10,000 in the second year of a $200,000 loan at 6 percent, you would save $41,044 over the life of the loan and the loan would be paid off in 26.5 years.
The first question to ask yourself before making extra payments on your mortgage is how long you want to stay in the house. If you plan on staying there into your retirement, extra payments may make sense. The house will be paid off sooner and you will save a lot of money. If you are planning on moving in two or three years, you will not be saving much in interest and there will be no effect on the loan term. If you have an adjustable rate mortgage and rates are low, you might think about making extra payments while you can afford them. Then when rates go up the interest portion of your mortgage payment will be based on a lower principal balance.
Another important question to ask yourself is what else you would do with the money. If your fixed mortgage rate is 5 percent and the savings rate is 1 percent, paying down your mortgage is a better deal. But if rates go up at some point and you can get 7 percent in a money market account, then putting the extra money there and letting it compound will bring more interest than the interest you would save on your mortgage. Savings are also liquid--you can get the money out of the bank in a minute. Once you make an extra payment on your mortgage you won't see it again until you sell or refinance your house.
If you have 23 more years to pay on your 30-year mortgage and you'd like to retire in 15 years, you do not have to refinance your mortgage into a 15-year loan or pay your bank a fee to have them set up an extra-payment plan. You can use an online mortgage calculator with the "extra payment" feature and figure out yourself how much and when to add in extra principal to have the loan paid off when you retire. If interest rates are much lower now than they were when you took out your loan, however, you may want to consider the refinance instead.
