4 Ways Homeowners Can Save Thousands When Paying Their Mortgage
Buying a home is likely the biggest investment you’ll ever make. Unless you’re paying cash, you’ll need a home mortgage loan to pay for your house. With a mortgage, your bank or lender will cover an agreed upon amount of the home (typically 80 percent), while you — the home buyer — puts down the remainder. Then, you’ll pay back the loan, with interest, each month over the course of the term (15 to 30 years).
Even at a low rate, interest adds tens of thousands of dollars to the cost of your home. For example, if your mortgage interest rate is 3.75 percent, every month, you’ll pay 3.75 percent interest on the amount you owe on the house. In those first years, a majority of your payment goes toward interest, and little toward principal. As you pay down the loan, less of your payment goes toward interest and more toward principal. Stretching the loan term out means a lower monthly payment, but in the end, you’ll actually end up paying more due to interest.
A $200,000 home on a 30-year loan with an interest rate of 5 percent would cost you more than $186,000 in interest over the life of the loan if you only make your minimum monthly payments each month. However, paying the equivalent of just month extra each year means you’ll pay off your loan four years early, and save more than $30,000 in interest.
Depending on your situation, paying off your mortgage early could mean big savings. Here’s how to make it happen.
Determine if paying off your mortgage early is the right financial decision — Before you jump the gun and start making extra payments at the expense of, say, your retirement, stop and evaluate your situation. At first glance, it may seem like a smart move to work towards paying off your mortgage early, but if making those extra payments means you aren’t investing money toward your retirement, then you will probably end up losing even more money in the long run. Financial guru, Dave Ramsey gives this example:
Let’s look at two homeowners with identical incomes and 30-year mortgages. Jane Homeowner makes her regular house payments and invests $500 a month toward retirement over the lifetime of her mortgage. By the time she retires, she could have nearly $2 million.
Joe Homeowner decides to double up on his house payments instead of investing for retirement. He pays off his mortgage in 15 years, but he has zero retirement savings. To catch up with Jane, he’ll have to invest $2,600 a month!
Look at it another way: Jane will invest a total of $180,000 for retirement. But because she started early, compound growth does the heavy lifting. Joe must invest a total of $468,000 for the same outcome—a $2 million-dollar nest egg and a paid-for home. Which bottom line looks better to you?
If you’re putting at least 15 percent of your income away toward retirement and still have extra cash to spare, then paying extra toward your mortgage may be the right decision for you.
Refinance to a Shorter Term — Most homeowners start with a 30-year mortgage because it offers the lowest monthly payments, but typically at a higher interest rate. If you have the cushion to make the extra payments, cutting your loan term in half by refinancing into a 15-year mortgage is a great place to start. Unsure if you can commit to higher monthly payments? Rather than locking yourself into larger payments by refinancing, start by paying the amount you would if you were to refi into a 15-year mortgage. If your financial situation changes and you can no longer afford the increased payments, you have the flexibility to return to making your minimum monthly payment. If you’d like to see what a mortgage comparison looks like broken down into monthly payments, use our Mortgage Payment Calculator.
Refinance for a Lower Interest Rate — Depending on when you originally financed your home, you may be able to refinance for a lower interest rate, which could mean big savings on your monthly payments. But rather than pocketing those savings, put them right back into your mortgage payments. If you want to try to get a lower interest rate, you’ll need to act quickly. Last year, rates hit an all-time low of 3.55 percent, but rates have been gradually inching higher and continue to climb. Today, the average rate is slightly above 4 percent and some experts predict they could reach 6 percent by 2019. So don’t hesitate. If you’re currently paying one percent or more of the market rates, now is the time to refinance and lock in a low interest rate, because rates won’t be on the decline again anytime in the foreseeable future.
Drop Mortgage Insurance — If you made a down payment of less than 20 percent when you financed your home, you’re probably paying Private Mortgage Insurance or PMI. If you’re on a conventional loan, once your balance drops to 80 percent, you can request that the lender drop PMI without refinancing. If you financed your home using an FHA loan, you’ll have to carry PMI for the length of the loan, unless you qualify to refinance under a conventional loan. If and when you are able, dropping mortgage insurance could save you a couple hundred bucks each month that can then be redirected toward your principal amount.
Tip: Getting a home appraisal may help you refinance to drop mortgage insurance even sooner if the value of your home has increased.
Save Your Windfalls — You may not have extra cash in your budget to put toward your mortgage, but that doesn’t mean you’re out of luck. Take any cash windfalls — tax returns, year-end bonuses, etc. — and apply them directly to your mortgage. Putting those one-time infusions of cash to work can help you put thousands extra toward your mortgage each year.
Tip: If you have other high-interest debt, it’s best to apply extra money toward paying that down before applying it to your mortgage.
Before you make any extra payments, speak to your lender to ensure those payments are applied toward principal rather than interest.
What works best for one homeowner may not work best for you. The good news is there are several means by which you can accomplish your goal of paying off your mortgage early. Choose the option that works best for you. If you have a consistent income and a steady budget, refinancing to a shorter loan term may be the best option. If your income is a little less consistent, or you aren’t confident committing to making higher monthly payments, simply make extra payments when you can. Every little bit helps, and even small additional payments toward principal can add up over time, saving you tens of thousands of dollars over the course of your loan.