Prepaying your mortgage is a great way to save thousands of dollars, quickly build equity and substantially shorten your loan term.
How much can prepayment save?
Say you have a 30-year fixed mortgage of $165,000 at 6 percent interest. The monthly principal and interest payments would be about $989, and you would pay $191,133 in interest over the life of the loan. By adding $25 a month, you could shorten the term by 23 months and save $14,734 in interest. For an extra $100 a month, you would shorten the term by six-and-a-half years and save $46,813 in interest.
So what's the catch?
There are a few. Your mortgage contract may include prepayment penalties. Check with your mortgage servicer first so you don't trigger them. Prepayment also reduces mortgage interest, which is tax-deductible, and may not be the most prudent course, depending on your tax situation. You also want to consider whether your return on investment might be higher elsewhere. And of course, any money you prepay becomes much less accessible.
Do it yourself
Budget an extra amount each month to prepay your principal. One tactic is to make one extra principal-and-interest payment per year. You could simply make a double payment during the month of your choosing, or add one-twelfth of a principal-and-interest payment to each month's payment. A year later, you will have made 13 payments.
Enroll in a biweekly payment plan
Many lenders offer biweekly plans that require you to pay half of your monthly mortgage payment every two weeks. This results in 13 monthly payments each year instead of 12.
Most biweekly plans carry an initial setup fee of a few hundred dollars, a processing fee of a few dollars per payment and don't offer much flexibility in a financial crisis. Still, many homeowners, and especially those paying biweekly, find this a good budgeting tool and are willing to pay for the convenience of a no-hassle prepayment plan.
Bankrate's mortgage calculator can help you figure out the impact of extra payments on your mortgage.
Once you have built sufficient equity in your home (and sometimes even before), you should ask your lender to remove your private mortgage insurance, or PMI.