You have a mortgage payment that you must pay each month. But what if you have extra money each month that you can either invest in the market or pay towards your mortgage? Does it make sense to put that money into your home or just pay the mortgage as scheduled?
Paying extra principal towards your mortgage obviously helps to pay your loan off faster, but what other effects does have on your loan and/or your personal finances?
Pay Less Interest
The quicker you pay the principal balance of your home down, the less interest you pay. While the interest you pay each month will remain the same (if you have a fixed rate loan), you may cut months or even years off your loan term with extra principal payments.
Let’s say you had an extra $100 per month to invest. You decide to put that $100 towards your principal balance. You effectively pay $1,200 per year extra towards your mortgage. If you do this consistently for many years, you can cut a few years off the end of your loan. This means fewer years that you must pay interest. This could translate into several thousands of dollars in savings.
Paying More Early Helps More
If you plan to make extra payments towards your mortgage, doing so early in the term has the greatest effect. In other words, you’ll knock off more time and interest if you make extra payments, even if they are small, towards your principal during the first five to ten years of the loan.
This is due to accrued interest. The earlier you knock your principal balance down, the less interest that accrues. In other words, paying extra money towards your principal on the second half of your term may not make as much sense. It will still knock time and interest off your loan, but it won’t have as dramatic of an effect as it would if you made those payments early in the term.
You Increase Your Equity Faster
Some people just like seeing their equity increase at a fast rate. If your home is one of your main investments, you want to know that you are getting a good return on your investment. Making those extra payments combined with increased values can help your equity increase at a faster pace.
If you think you may need to rely on your equity before your loan ends, picking up speed and gaining more equity faster can be beneficial for you. Let’s say in five years you suffer a serious emergency and need cash fast. If you paid your mortgage down faster, you’ll have more equity to tap into when you need it. If you left the money in a savings account, it will be there, but will have grown very little interest. The equity in your home can increase exponentially with the appreciation of home values.
The Money Isn’t Liquid
Something you must keep in mind when deciding if you should pay down your mortgage faster is the money isn’t liquid. If you need the money fast, you’ll have to wait at least 30 days for a refinance to get approved and closed. What if you don’t get approved? Then the funds remain invested in your home and you can’t have access to them unless you sell the home.
If, on the other hand, you invested the cash in stocks, bonds, or mutual funds, you could cash out your investments as you see fit and take the cash within a few business days. Obviously, the most liquid use of your funds would be in a savings account or money market account, but the return on your investment in these investment vehicles is usually so minimal that it doesn’t make sense to do so.
Before you pay extra money towards your principal, look at the big picture. Run an amortization schedule using your extra payments to see the effect on your loan. See how many years and how much interest you will save. You may even want to compare the difference between making extra payments for the entire term and just for the first half of the term. Look at the dollar-for-dollar return and then compare it to your other investment options before you decide what to do.