Paying extra on your mortgage principal: is it the right option for you?
At the core of every mortgage payment are two main components: principal and interest. The difference between them is fairly simple. The principal is the actual money borrowed; interest is the amount you pay the financial institution for lending you the money to buy your home.
If you have a fixed-rate mortgage, the total amount you pay each month will remain the same for the life of the loan. However, the amount of your payment that goes to the principal, and the amount that goes to paying off the interest you owe, changes every month.
At the start of the loan, the amount of interest you pay each month is much higher than the amount of principal. This is because at the beginning, you still owe a lot of your principal, so your interest payments are higher. Over time, as you pay down your principal, the amount you pay toward interest gradually goes down. By the time you reach your final payments, they’re mostly going toward the principal, with just a small portion going toward the interest. This process of balancing out the principal and interest each month to keep your payments at a steady amount is called amortization.
Most mortgages provide you the option to pay extra on your principal if you wish. You could, for example, pay an extra $50 or $100 each month, or make an extra mortgage payment each year. The benefit in taking this approach is that it will, over the life of the loan, reduce the total amount of interest you pay. If you do this from the beginning, you have the potential to save thousands of dollars in the long run.
This sounds like a great idea, right? For some people, it is. In many cases, however, while it’s a good option, it may not be the best. That’s because there’s an opportunity cost involved: if you pay extra money toward your principal, you can’t use that money for anything else.
To further illustrate the point, let’s take a look at a few areas that, depending on your situation, may be better uses of your money than paying down your principal early.
Your rainy-day fund. Emergencies can put an enormous strain on your budget if you don’t have anything set aside to pay for them. It’s ideal to have somewhere between three to six months’ worth of your household take-home pay set aside to help you deal with the unexpected. Build up this fund in a savings or money market account before paying extra on your mortgage.
Your 401(k). If your employer offers any kind of match on your contributions to your 401(k), ensuring you’re getting the full match amount is an absolute must. In most cases, you’ll earn much more from your 401(k) contributions in the long run than you would save by paying extra on your principal. Even if you don’t have a 401(k) available to you, there are plenty of investment options out there that can provide a better rate of return than what you might save on your mortgage interest.
Your monthly budget. Saving on mortgage interest is great, but if it makes your monthly budget too tight, it may not be worth it. For example, if you have a balance on your credit cards, it’s better to pay down that balance – which is likely at a higher interest rate than your mortgage – than to use it for your principal. Pay your monthly bills first.
Another factor to keep in mind is how long you intend to own your current home. If you’re only planning to stay in it for a few years, you probably won’t see much benefit of paying extra on your principal. On the other hand, if you’re planning to stay for a long time, then a little extra money every month can add up nicely to save you quite a bit on your interest. Just make sure your mortgage doesn’t have any prepayment penalties attached to it. Most don’t, but it’s best to make sure.
If you do elect to pay extra toward your principal, it’s important to note that you usually have to earmark the extra money for that purpose. Otherwise, it may get applied to your mortgage as a whole. The method for earmarking your additional payment is usually simple, but it varies by lender, so be sure to ask for instructions.
Under the right circumstances, paying extra principal can result in considerable savings, and can allow you to be mortgage-free well ahead of schedule.
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