Q: I saw your video on your YouTube Channel (youtube.com/expertrealestatetips) on how making an extra payment on your mortgage pays your loan down faster. When you make an extra payment, do you apply all of that to principal or just a normal payment as usual? What if I could pay extra to the loan? Should I apply all of that to principal?
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A: You might be a bit confused about how prepaying your mortgage works and what actual benefits accrue when you do that.
Your monthly mortgage payment is made up of what you owe on your loan for the repayment of principal and the payment of interest. For most borrowers, you may also have a payment to the lender toward your escrows for the payment of real estate taxes and homeowner’s insurance. Finally, you may also have to make a payment toward your mortgage insurance.
Let’s start with your escrow payments. Your lender wants to make sure that the real estate taxes on your home are current and paid at all times. The lender also wants to make sure you have insurance in place to pay for the repairs to your home should a casualty occur.
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Now, when you have to pay mortgage insurance, this insurance is only for the benefit of the lender. Mortgage insurance covers the lender in case it forecloses on your home and loses money on the sale. (Mortgage insurance may cover only part of the lender’s loss, but it’s only for the benefit of the lender. If you are paying mortgage insurance, it’s because you decided to get or had to get a mortgage that was more than 80 percent of your home’s value.)
Depending on the type of loan you have, your principal payment may be fixed for the 15-year or 30-year term of your loan. That means your monthly payment that goes toward principal and interest won’t change during the term of your loan. Your overall payment may change as real estate taxes and insurance costs change, but what you pay toward your principal and interest stays the same.
On the other hand, variable-rate mortgage products may give you a fixed payment for, say, three or five years, but after the initial fixed period each year after that, your payment may change. You should also know that in these products, as interest rates go up or down, the lender reamortizes your loan. The lender must change the amount you need to pay on the loan so that you end up paying off the loan at the end of the term.
Back to your question. When you want to reduce the term of your loan from, say, 30 years to 25 or 23 years, you must pay the lender extra money toward the principal. In other words, if you took out a fixed-interest loan for $100,000 on a 30-year term, you’ll pay off that loan in full at the end of 30 years. To shorten the life of the loan, you’d have to pay extra to bring down the principal amount of $100,000.
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On a fixed-rate mortgage like this one, you could pay off $20,000 the day after you take out the loan; that would shorten the loan by many years. Your monthly payments are fixed, so you’ll need less of those payments to pay off the $80,000 than you would to pay off $100,000. So, to your question, your extra payments must always be made to reduce the principal on your loan. On your coupon book, you may see a line item where you can write in the extra amount you are paying to reduce the principal balance on your loan.
As a side note, if you pay down the principal on a variable-rate loan when the lender reamortizes your loan to reduce your loan payments, you’ll still end up with a 30-year loan term. The only way you can reduce the term is to continue to prepay the principal on the loan, continue to make the same payments as the interest rate goes down and pay the higher amount as interest rates go up plus the extra amount you want to apply toward principal. As you reduce the principal on the loan and if interest rates stay about the same or go down over the life of your loan, eventually your monthly payments may be so small that you can make one final payment to pay off the loan early.
The only exception to this with adjustable-rate mortgages is when interest rates are going up and if your payments to reduce the principal on your loan don’t significantly reduce the loan balance; you’ll still end up making monthly payments for the entire term of the loan, but any reductions on principal payments you would have made should have saved you on the amount of interest you paid over the life of the loan.
FAQs
The only way you can reduce the term is to continue to prepay the principal on the loan, continue to make the same payments as the interest rate goes down and pay the higher amount as interest rates go up plus the extra amount you want to apply toward principal.
Can you pay off a fixed-rate mortgage early? ›
Prepayment penalties can be equal to a percentage of a mortgage loan amount or the equivalent of a certain number of monthly interest payments. If you're paying off your home loan well in advance, those fees can add up quickly. For example, a 3% prepayment penalty on a $250,000 mortgage would cost you $7,500.
How can I get out of a fixed-rate mortgage early? ›
How To Get Out Of A Fixed Rate Mortgage Early
- Switch to a more advantageous or better-suited interest rate. You may have fixed your mortgage at a competitive rate at the time, but rates may have improved since then. ...
- Remortgage. ...
- Moving home. ...
- Repay all or part of your mortgage.
Here are some ways you can pay off your mortgage faster:
- Refinance your mortgage. ...
- Make extra mortgage payments. ...
- Make one extra mortgage payment each year. ...
- Round up your mortgage payments. ...
- Try the dollar-a-month plan. ...
- Use unexpected income. ...
- Benefits of paying mortgage off early.
Paying a little extra towards your mortgage can go a long way. Making your normal monthly payments will pay down, or amortize, your loan. However, if it fits within your budget, paying extra toward your principal can be a great way to lessen the time it takes to repay your loans and the amount of interest you'll pay.
What happens if I pay an extra $1000 a month on my mortgage? ›
When you pay extra on your principal balance, you reduce the amount of your loan and save money on interest. Keep in mind that you may pay for other costs in your monthly payment, such as homeowners' insurance, property taxes, and private mortgage insurance (PMI).
What happens if you pay off a fixed rate loan early? ›
The interest rate on the money we borrow is known as the 'cost of funds'. If you make additional repayments, or pay out your fixed rate loan early, the original loan term remains the same. Accordingly, an economic cost is charged to us and this is why we pass this cost on to you.
Is it worth paying off a fixed-rate mortgage early? ›
This is because you'll save a significant amount on the interest that makes up part of your payment agreement. Paying your mortgage off early means you won't have to pay interest on the months you no longer need to pay, saving thousands of pounds as well as ending your mortgage years earlier.
What is the penalty for ending a fixed-rate mortgage early? ›
Your lender will use the highest of two calculations for your penalty, the IRD (Interest Rate Differential) or 3-month interest — IRD is usually the highest.
What is the penalty for paying a fixed rate mortgage early? ›
If you were to exit your fixed-rate mortgage while locked into an introductory rates period, the main consequence would usually be having to pay an early repayment charge. This is normally a percentage of the loan amount, typically somewhere between 1% and 5%.
How much does an early repayment charge cost? The cost of an ERC is based on the outstanding mortgage amount and the point at which you are in your deal. Typically, ERCs range from 1% to 5% of the remaining loan, and this percentage tends to decrease each year you're into the deal.
How much is it to break a fixed mortgage? ›
For Fixed rate mortgages, the prepayment charge will be the greater of 3 months interest or interest for the remainder of the term on the amount prepaid calculated using the interest rate differential. For variable rate mortgages, it is 3 months interest.
How to pay off $170 000 mortgage in 5 years? ›
How to Pay Off Mortgage in 5 Years
- Refinance to a Shorter Term Mortgage Payment Schedule. ...
- Make Biweekly Payments. ...
- Round Up Your Mortgage Payments. ...
- Allocate Windfalls to Mortgage Payments. ...
- Make a Substantial Down Payment. ...
- Increase Your Monthly Payments. ...
- Lump-Sum Principal Payments. ...
- Assistance in Paying the Mortgage.
Increasing your monthly payments, making bi-weekly payments, and making extra principal payments can help accelerate mortgage payoff. Cutting expenses, increasing income, and using windfalls to make lump sum payments can help pay off the mortgage faster.
How to pay off $200 000 mortgage in 5 years? ›
Let's say you currently owe $200,000 on your mortgage and you want to pay it off in 5 years or 60 months. In this case, you'll need to increase your payments to about $3,400 per month.
Is there a penalty for paying off an ARM loan early? ›
Prepayment penalties.
Some ARMs, especially interest only and payment options, charge fees if you try to pay off the loan early. That means if you decided to sell your home or refinance it, you will pay a penalty on top of paying off the balance on your loan.
How do I get out of an adjustable-rate mortgage? ›
You can refinance an ARM loan and by doing so, you'll replace your existing mortgage with a new one. In this case, it can be either another ARM or a fixed-rate mortgage.
Can you pay off a 5 year ARM mortgage early? ›
A 5-year adjustable-rate mortgage (5/1 ARM) can be paid off early. However, there may be a prepayment penalty. A prepayment penalty requires additional interest owing on the mortgage.
What happens if I pay an extra $200 a month on my mortgage? ›
When you pay extra on a mortgage, you're paying above and beyond the regular monthly installment. The money you send is meant to apply directly to the loan principal, not the interest. This allows you to pay down your loan sooner and save money on interest.
