Think it's a raw deal that you pay far more interest on your mortgage than you receive on your savings?
There's a quick way to wipe out that gap
and get the same earnings -- in some cases even higher
-- that you pay out: Take the amount of money you would
put into a savings account and pay extra principal on
your mortgage, instead.
In other words, if you have a 6.5 percent mortgage and you make an extra payment against principal, you have an investment that yields 6.5 percent.
While prepaying isn't for everyone, financial
advisers say it's often a smart savings strategy. Among
the advantages: low risk, flexibility and easily measured
savings. Plus, there's a reward at the end.
Such payments, directly reducing outstanding
debt, have long ranked as a popular technique to accelerate
the journey to owning a home outright by shortening
the life span of a mortgage.
"You get to actually own your house
-- which is a lot more comfortable position to be in
than a stock certificate or bond if times get tough,"
says Marc Eisenson, co-founder of Good
Advice Press, a publisher of debt reduction books.
"Also, your savings are liquid. You can get a home
equity line of credit or loan if you need it."
Calculated over many years, small payments
add up to substantial savings. A homeowner with a 30-year
mortgage for $200,000 at 6.5 percent interest, for example,
could save $56,000 in interest costs over the life of
the loan by forking over just $100 extra every month.
While prepayment amounts vary, a common approach is
to pay the equivalent about one extra monthly payment
each year. Doing this annually would allow someone to
pay off a 30-year mortgage in 25 years.
Consider it an investment
The best way to determine if prepaying is a wise financial move is to compare it to all other investment options.
That's the advice of Jack Guttentag, professor
of finance emeritus at the Wharton School of Business
and founder of the Mortgage
Professor's Web site. He tells homeowners to view
prepayments as investments bearing interest equivalent
to their mortgage rate -- a prepayment on a 6-percent
mortgage is the same as an investment that yields 6
"If you can earn 6 percent, and it's a sure 6 percent, and there's no risk involved, then the question is whether you can do better somewhere else," Guttentag says. "For most people, the answer is no."
But there are exceptions. Younger homeowners
might be better off funneling savings into a diversified
stock portfolio. While that's risky in the short run,
over the long term it's likely to prove to be more lucrative,
Donna Wood, a CPA and financial planner
in Haymarket, Va., advises clients often to put money
into 401(k) plans before prepaying on a mortgage. In
many cases, employers' will match 401(k) contributions
up to a certain limit. Wood tells clients to contribute
at least to that limit and secure the money in a diversified
portfolio before exploring others savings strategies,
such as prepaying. Eisenson also advises homeowners
with outstanding credit card balances to concentrate
on eliminating their high interest-bearing debts before
paying off mortgage principal.
on nontraditional loans
Today, fewer homeowners hold only traditional 15-year
and 30-year mortgages. Alternate debt instruments, such
as adjustable-rate mortgages, or ARMs, home equity credit
lines, and interest-only loans, have proliferated. As
use of these alternate loans grow, so do homeowners'