When you get a loan, you may have the option of Pre-Payment, i.e., you can send in extra payment to pay down the loan faster. This extra payment doesn’t have to be a full month amount — it can be any amount, e.g., $100, $200, $5000, etc. When you do this, make sure you make it clear to the lender that you want the extra payment applies toward your Principal balance; otherwise, they may apply it toward your Interest Charges — which is not good.
Why You Might Want to Pre-Pay
The main argument for making extra payments is to reduce the length of your loan and the amount of interest you have to pay. Simply, if you’re paying 3.5% interest rate on the mortgage, you’re avoiding interest payment on the amount that you pre-pay. Depending on how much you payoff early, this could be a significant amount of money.
If you’re planning to make pre-payments, the best time to do it is early in the life of the loan. This is when most of your payment goes toward the interest as opposed to the principal. For example, take a look at amortization table below (this is for a $300,000 loan at 3.5% amortized over 30 years).
In the first year, $6,467.09 goes toward the Interest versus only $1,117.73 toward the Principal. Your extra payment toward the Principal will have a much more significant impact in the first few years.
Why You Might NOT Want to Pre-Pay
On the other hand, you may not want to make early payments if have something better to do with that extra payment. For example,
- Pay down other debts with higher interest rate, e.g., car loan, credit card debt, etc.
- Investing in a retirement plan
- Investing in other investments
- Investing in a business
- Saving for a down payment on a rental property
Secondly, remember that long-term inflation rate is 2-3% per year. Over the life of the loan, your mortgage payments will progressively become a less significant amount of money over time. Since the current interest rates are relatively low, you could consider letting inflation does its job.
Do you make extra payment on your mortgage? Why or why not?