If you have more than one outstanding mortgage or loan on your house, it's logical to prepay the one with the higher interest rate. But determining which loan is costliest can be tricky with ARMs, where interest rates fluctuate.
Guttentag advises ARM-holders to consider
both their present and future interest rates when deciding
whether to prepay. If today's interest rate is 5 percent,
prepaying might not seem imperative. But if it's likely
to rise to 10 percent in the next several years, reducing
outstanding debt becomes far more appealing. Every dollar
of principal that you pay off today may be earning the
rate you may have to pay in the future. The same is
true for home equity lines of credit, says Wood. By
paying down a loan, borrowers help ensure that future
interest charges will be smaller. As for interest-only
loans, Wood says, prepaying is wise because it allows
homeowners to build equity.
But before sending in that extra check, it's important to make sure it won't cost you. Some lenders, particularly those who market to borrowers with damaged credit, charge penalties for prepayment.
Prepayment penalties are exceedingly rare
for conventional or government-backed loans, says David
Reed, president of CD Reed Mortgage Bankers in Austin,
Texas. In the subprime loan market, however, Reed estimates
that around one in four mortgages contain some sort
of prepayment penalty.
On the flip side, prepaying may also be less desirable for homeowners fortunate enough to have locked in low fixed interest rates. If one is paying 4 percent interest on a mortgage, for example, purchasing a government bond yielding 5 percent interest would be a more lucrative move than prepaying.
Do it yourself
Prepaying on a mortgage should save you money. But paying someone else to handle the payments could reduce or eliminate those savings.
That's why Reed tells homeowners to be
wary of many heavily marketed prepayment programs. Most
charge a fee, commonly $300 or $400, to set up payments.
"I say prepay all you want, just make sure you're not in one of those goofy biweekly programs you have to pay money for," he says. "Just do it yourself."
Before sending in more than the minimum mortgage payment, Reed advises contacting one's lender about how best to go about making a prepayment. Loan origination documents should also include prepayment information, including any possible penalties. Some mortgage bills include a box to check off if extra principal payment is included. In other cases, homeowners may write a separate check, marked "principal only."
There's no hard-and-fast rule about how much to prepay.
Determining the right sum involves analyzing such factors
as one's living expenses, other outstanding debts, risk
tolerance and alternate investment options.
There's also no set way to schedule prepayments. Homeowners who get paid every two weeks may feel comfortable with a biweekly payment plan. This involves paying half of the monthly mortgage bill every two weeks, which effectively adds up to paying an extra month's mortgage each year. Another common approach is to tack on an extra 10 percent to the regular payment.
Ultimately, it's a personal decision, says Eisenson.
"The amount to allocate between debts
and more traditional investments is an individual matter,
with each of us having to decide how much of a risk
we are willing to take, how much comfort we require
and what our priorities are," he says. "Mine
would be to have a house I can afford to live in and
isn't likely to be taken away from me, should times
Joanna Glasner is a freelance writer in California.