Prepaying can save thousands in mortgage interest

Thinking about killing off that mortgage and saving thousands of dollars? Thought so.

Experts say most people can get that exact deal by sending their mortgage lender a few extra dollars each month. There are some things to consider before taking that step but, once the decision is made, just forty bucks every four weeks can knock five years off the life of a loan.

It's simple
"The bottom line is, send in more than you're required to send in, whenever you can, and as much as you can," says Marc Eisenson, author of The Banker's Secret, a consumer's guide to prepayment. "Everything else is details."

Mortgage prepayment, or "accelerated payment" as it is sometimes called, has long offered homeowners the chance to be as free and clear on their homes as many are on their cars. The strategy, while executed in any number of ways, has one basic rule of thumb: a borrower pays money sooner than required.

With a 30-year, fixed $100,000 mortgage at an interest rate of 7 percent, for example, a borrower would have monthly principal and interest payments of about $665 and accrue $139,502 in interest over the life of the loan. By adding $25 a month, the same borrower would shorten the term by just over three years, and save $18,212 in interest. With an extra $200 every 30 days, interest savings would total $72,690, and the loan would be paid off in about 16 years.

"The nice thing about all this is that it's arithmetic and not intelligence," says Lew Wallensky, a Los Angeles certified financial planner with Lewis Wallensky & Associates.

Prepare the way
Borrowers deciding to take the plunge should steer clear of costly plans touted as alternatives to doing it on their own, consumer advocates say.

The formal plans typically charge a one-time membership fee of around $400, plus $3 in service costs every two weeks, Eisenson says. Once enrolled, a person either mails biweekly payments to the company, or has them automatically deducted from an account. In return, the plan ends up sending the customer's lender one extra monthly payment a year -- something a borrower could easily do by dividing the monthly payment by 12 and sending in that amount without help.

So how does a borrower go it alone? First, contact the lender to find out how to ensure the money ends up in the right place. Some customers may need to write "Principal Only" on their checks. Others may have to send separate checks each month, or mark off special boxes on their statements.

Prepayment penalties can be another trip-up. They typically kick in only when a borrower refinances, but some can activate if a person pays more than 20 percent of the loan's principal during any one year early in the loan, according to the Mortgage Bankers Association of America. The penalty can be as much as six month's interest on the amount paid that exceeds the lender's allowed prepayment.

Other options
For all of its ease, however, prepaying isn't always a consumer's best bet.

Consider a few simple points: When borrowers prepay, they save interest, which is like earning money at a certain rate of return. That return equals their mortgage interest rate, minus any benefit from the tax deduction they would have been entitled to because they paid that interest.

For example, a person with a 7 percent interest rate and 28 percent federal tax rate earns about 5 percent after factoring in the tax deduction. That's less than the stock market's historical average return of 8 percent to 10 percent, and far below the numbers seen of late.

"Financially, there's a good argument for not paying it off because every dollar you prepay on a mortgage is earning only the face interest rate on that mortgage," says Jon Richards, a San Francisco-area college instructor. "You're far better off taking the money and opening a mutual fund. At the end of 10 or 15 years, you would have more than enough to pay off your mortgage."

Consumers with children heading off to school in the near future may also want to sock money away rather than prepay, Wallensky says. "If they know that five years from today they're going to need $50,000 and they can put an extra $10,000 into the mortgage for accelerated payments or put it into an investment account, they'd be better off putting it into a second account rather than giving it to the banker."

That's because money sent away for a prepayment is money a consumer won't see again -- potentially reducing liquidity to a dangerous level should a financial crisis arise.

"It wouldn't make any sense if the person doesn't have any money in reserves or if they don't have an emergency fund," says Steve Rhode, president of Debt Counselors of America. "You don't want to take your last $10 each month and send it to the mortgage company."

However, prepaying remains a great way to retire debt and build home equity quickly, all the while earning a reasonable rate of return, experts say. And that doesn't take into account rewards which can't be measured in dollars and cents.

"There's a lot to be said for owning your house, and until you've paid it off, you don't," Eisenson says. "If you really want to live the American Dream and own your house, you've got to get rid of the debt."