Stash extra cash in emergency fund
Dear Dr. Don,
I am currently in a position that would allow me to make two house payments per month. Would it be better for me to apply the additional money toward the principal each month or to make the monthly payments ahead of schedule?
By doing the latter, I would be ahead of schedule on payments and could skip paying for the amount of time I had paid ahead, in the event my situation changes. Please advise me.
— Ted Twixt
There’s a big difference between making an additional principal payment to the monthly mortgage payment and making additional mortgage payments ahead of schedule.
You should ask your lender how it will account for the additional mortgage payments. Typically, an additional mortgage payment results in the homeowner giving the lender an interest-free loan until that payment comes due. It’s hard to argue for that approach.
If you are worried about your circumstances changing, it is better to use the money to establish an emergency fund. An emergency fund is normally sized for three to six months worth of living expenses.
The Bankrate feature, “Creating an emergency fund,” goes into depth in how to size and invest an emergency fund.
Making additional principal payments reduces your total interest expense and shortens the life of the loan, but it doesn’t change the size or the due date on next month’s mortgage payment.
You can use the amortization schedule on Bankrate’s “Mortgage payment calculator” to see how additional principal payments change the total interest expense and shorten the loan term.
After significantly reducing the principal balance, some lenders will allow you to recast your loan to reduce the size of the monthly mortgage payment. You’d want to know if this option exists before getting too aggressive in paying down the mortgage if your goal is to gain some financial flexibility during a financial crisis.
Take a look at the big picture, too. If you’re not taking advantage of a company-matching program in your firm’s 401(k) plan, contributing up to the limit of the matching program is a good place to invest some of this money.
Your age, number of years until retirement and attitude toward risk will influence whether you’re better off paying down the mortgage or using these funds to invest in something other than real estate.