Making extra payments on your mortgage? Is prepaying your mortgage the right move? Do you save any money when you prepay?
I am not talking about “paying down your mortgage.” I am talking about prepaying your due payments for your mortgage. For example it is currently January and I’m talking about prepaying for March – December. Why would I want to do this? Simple – Save money.
How it SHOULD WORK:
Example: You have loan for $100,000 @ 4% – and let’s assume your payment is $740 a month (15 year). You prepay an 10 months of payments (rest of 2012) – then stop paying for this year.
Monthly interest rate: Roughly .328%
You gave your December payment 10 months early,
You gave your November payment 9 months early,
You gave your October payment 8 months early,
It is my opinion that since you have effectively given that money in advance, you should not pay interest on that lump sum you handed over. It is my belief that the balance of the loan should go down by $740 for each payment and you should be mark as “completed for payment” for the months you paid in the bank’s system. So I believe it should works as follows:
You prepay 10 months (March – December) of $740 on your $100,000 loan. No payments are due for the rest of the year and the balance INSTANTLY becomes: $92,600.
You then accrue interest on that loan, building your balance back up. Chart below shows.
Leaving your balance at $95,682.50 for the year (numbers are rough because of percentage is not 100% accurate, but you get the idea).
Sadly this is not how most banks treat this action of prepayment.
Bank’s will usually hold your payments INTEREST FREE until time of payment. Effectively they hold your money, earn interest, and make the payments when you normally would have made without prepayment. So much how much interest are they taking from you? Look at the chart to the right. $134.82 that the bank effectively steals from you from not adopting the logical way of applying the payments.
Now your balance would be $95,817.32 (+$134.82) instead of $95,682.50.
I recently called my personal bank to which the representative was fairly certain the money was held interest-free. I will also contact them a second time to see if I can make special arrangements.
Why does this matter? If your mortgage is properly setup, you can use your mortgage as sort of like a CD. You give the bank an extra $7400 and they give you back $134.82 for holding your money. If you always kept a 12 month prepayment on this loan above (when one is used, you replace) you would net roughly $296.57 every single year! Who’s saving’s account or CD is paying 4% yearly (or higher if your loan is on a higher interest rate).
Why is it “sort of like a CD?” Because you can stop prepaying and you get your money back over time. Sure with a CD you can get the entire lump sum back, but it also has penalty. With this method it would take you how ever many months you have prepaid to get back 100% of your money, but penalty free. Now I know the first comment or thought is this – “My interest is deductible” and I agree that if your itemizing, then this would only net you ( 1 – [margin tax rate] ) * interest saved, but this example of only a loan of $100k – so you might not be itemizing. Plus as you continue to pay your mortgage there will come a point where you suddenly start taking the standard deduction (most likely – and hopefully).
Just so we are clear with all of this – You are not giving the bank a dollar more, just allowing them to hold your money. If you have a fairly large sum in your savings/checking –why wouldn’t you take a little extra free money?
It is sad that most banks do not operate in a way that pays you for prepaying your mortgage and I think there is a real market for people who are looking for higher guaranteed return on their money. I understand there are complications with what I am proposing though – big ones. If you prepaid 50 payments on your mortgage and when to take out a Home Equity Line of Credit (HELOC) your balance would be artificially low. Suddenly your mortgage would be $37,000 smaller, allowing you to borrow too much and effectively cause a reverse amortization of your loan as the interest accrues. Simple solution to that, add back in prepayments for the balance used for calculating the HELOC.
Looks like I need to start a bank.