People who are conservative with their finances love the idea of making extra mortgage payments in an effort to pay their loans off early. As sound a tactic as this can be, it's not something you should rush into without first asking some key questions.
Mortgage Prepayment Has Obvious Benefits
Generally speaking, paying down a mortgage early will save you on total interest payments over the life of the loan, because it will result in you owing money for a shorter time. On top of that measureable benefit, there's the fact that some people simply like the idea of owning their homes free and clear, and want to get to that point sooner.
In short, there are strong reasons for making extra mortgage payments, but ultimately, you have to think about this as an investment strategy. It may pay off in the long run, but in the meantime it requires the outlay of a significant amount of money. Like all investment decisions, this one requires some critical thinking before you commit, including considering alternatives such as whether it's better to refinance a mortgage or put the money to a different use.
But It May Be Smarter to Refinance
Therefore, before you start making extra mortgage payments, here are six questions you should ask yourself:
1. Do you have more expensive debt to pay off? Federal Reserve data as of the second quarter of 2013 showed the average credit card interest rate being charged at 12.76 percent, and if you have any dings in your credit history, you may be paying considerably more on your credit card balances. The point is that there are much more expensive forms of debt than a mortgage, so if you have extra money at hand, you can save more by paying off higher-interest debt first.
2. Should you be refinancing instead? If you find you regularly have extra money to put towards your mortgage payments, consider whether it makes more sense to refinance a mortgage than to pay off the existing loan ahead of schedule. Specifically, switching to a shorter mortgage could help you get a better refinance rate, since shorter-term loans usually offer lower interest rates than longer-term ones. For example, according to Freddie Mac, as of mid-2013 30-year fixed mortgage rates were nearly a full percentage point higher than 15-year rates. If refinancing a mortgage to a shorter loan allowed you to reduce the interest rate you are paying, you could gain additional savings because you would be both shortening the time over which you are paying interest and paying a lower rate. Just be sure there is ample room in your budget for the higher monthly payments that typically come with a shorter loan.
3. Are there extra fees involved? Depending on the type of mortgage you have and when you got it, there may be prepayment fees incurred if you pay some or all of the balance off ahead of schedule. You'll want to look into this, and if there are such fees, you'll need to figure out whether the interest you would save by paying the mortgage off early would exceed the extra charges you would incur.
4. Will you need to take equity out of the house in the next few years? During the housing boom, it was often said that people treated home equity like a piggy bank, building it up and then taking money out whenever they wanted. Home equity loans can be a useful tool, but they come at a cost. If you anticipate a need for borrowing against home equity in a few years, you might be better off putting the extra money into a savings account where it can be easily accessed instead of making extra payments towards your mortgage.
5. Do you have an emergency fund? Even if you don't have a specific need for the extra money on the horizon, make sure you have some cushion against setbacks. When you make extra payments towards your mortgage, it shortens the number of payments you will owe on the back end of the loan, but it does not mean the mortgage company won't expect you to make your next payment on time. Therefore, having some money set aside for financial emergencies can save you from getting caught short.
6. How secure is your future income? Even with early payments, chances are you still have a long stream of payments ahead of you that must be made on schedule. Both points 4 and 5 above touch on the fact that once you put money into home equity, it isn't necessarily easy or cost-free to take it out. Making extra payments on your mortgage should involve a judgment that you not only have extra money now, but that you expect to have ample income available to make your mortgage payments for the foreseeable future.
If you are satisfied that the answers to these questions point to the wisdom of paying your mortgage off early, then go for it. You'll not only be on track to save yourself some money, but you can rest easy knowing you've made the decision after a thorough examination of the issues.