What is prepayment? Well, it’s just what the name implies: paying off all or a portion of your loan before it’s due. Unfortunately, it’s not quite as simple as just adding more money to your monthly payment whenever you want to. Your lender may or may not approve of prepayments in any amount. You must first check your mortgage contract to see if there are any clauses that would result in prepayment penalties.
Why Would a Lender Mind Prepayments?
Lenders are in the business of lending money in order to make money, in the form of service fees and interest. They need to have the loan open long enough to receive an adequate profit for themselves and/or their investors. If you decide to prepay part or all of the principal balance, then that is interest (or profit) that they will not receive. In order to recoup a portion of this lost profit, lenders will insert a prepayment penalty into the contract as a means of discouraging you from prepaying too much too early. They cannot, however, stop you from prepaying; you have every right to do so if you wish to.
Advantages of Prepaying Loans
Prepaying has a number of advantages, not the least of which being that you will be that much closer to owning your home free and clear. After all, that is the ultimate goal in buying your home in the first place, is it not? Prepayment also has the added benefit of saving you literally thousands of dollars in interest. For example, a 30-year loan that is paid off in 15 or 20 years would save the borrower tens of thousands of dollars! And equity in the home is built up that much faster, as well. Use our What if I Pay More Every Month? Calculator to examine some numbers for yourself.
Disadvantages of Making Prepayments
Of course, you must consider and weigh all sides of the issue. There can be disadvantages to prepaying. For one, you’ll be using dollars that you could use elsewhere, or for savings. Those funds could also be used for other investments, ones that could potentially yield higher returns. Also, prepayment of lower interest rate loans will not produce the same savings impact as prepaying loans of higher interest. And because mortgage interest is generally tax-deductible, paying less of it could have a significant bearing on your tax situation (use our Tax Benefits Calculator to help you compare numbers). You must closely monitor you mortgage to insure that your prepayments are properly applied to your principal balance, as well.
Is Prepayment Right for You?
Is prepayment, therefore, a wise decision? To answer that question, you must weigh the advantages and disadvantages with regard to your own personal circumstances. You must also consider your short- and long-range goals and financial position. Would the money you use for prepayment be better used for other important expenses, such as tuition or health care? Do you intend to keep the property for a long time, or will you sell it in a few years (thus nullifying the benefits of prepayment savings over the life of the loan)?
Prepayment can be very beneficial, and surprisingly easy. A number of strategies are available; one such that you may have heard of is the bi-weekly plan. Consider the matter according to your own financial position and goals, and then make the decision that’s best for you.