Congratulations! You’ve decided to refinance. You are on the path to better interest rates, lower monthly payments, more cash in your pocket, and the promise of some serious savings over the long term. You’ve circled your break-even point in red on your calendar, and can’t wait to find all sorts of things to do with all the money you’ll be saving.
It can be tempting to “take the money and run,” in a sense, and turn the money you save by refinancing into an investment, or even just additional cash on hand. Those are certainly valid plans for your money, but you might consider spending it upfront on the very expense you just reduced” your mortgage.
A Matter of Principal
When you make extra monthly payments to your mortgage--any amount above the minimum required by your lending agreement--you can specify that you want that money targeted toward your principal loan amount. Normally, your monthly payment applies to a combination of principal and interest; the exact ratio varies depending on how far along you are into repaying the loan.
As you know, interest is front-loaded on your mortgage, meaning that in the beginning most of what you pay is applied to interest, and it is only as you get closer to paying off your mortgage that the balance shifts to the principal relative to the interest. By paying extra, however, you can shift this balance from the very beginning, bringing you closer to eliminating the debt and setting you up for powerful savings on interest over the life of your mortgage.
By paying additional principal, you can make the compound interest mechanism work for you. Less principal owed means a smaller outstanding balance, which means your interest rate is applied to a smaller whole. This doesn’t matter much on a monthly basis, but over the course of repayment, you will find that your net cost in interest is significantly less than if you had stuck to the full-term repayment schedule.
Postponing Your Savings
Of course, if your goal was to free up your money to spend elsewhere, then it may not suite your plans to devote any more to your mortgage than is absolutely necessary. But if you refinanced as part of an overall money-saving effort, these extra payments can be a powerful contribution to that goal.
A helpful way to think of it is to simply pay the same amount you would have owed had you chosen not to refinance. That way, your monthly bills look the same, but the aggregate effect is that you are saving money. While the full savings won’t show up at first, paying extra toward your principal will allow you to pay off your mortgage sooner, as well as undercutting the full interest you might have otherwise owed.
It can be hard to commit to this sort of effort, because it doesn’t feel like you are saving money upfront. But when you compare the amortization schedule set out by your lender with the total amount you will end up paying, your numbers will look much more favorable.
Going Debt-Free with Flexibility
This is particularly worth considering if you are torn between which mortgage term to pursue by refinancing. With a 15-year mortgage, you are locked into paying a higher monthly rate. If you aren’t completely confident you will be able to consistently make payments at this rate, the 30-year may be the safer route for you. But you still have the ability to pay it off sooner than 30 years down the road, by making additional contributions to the principal whenever you can afford it.
Although a 30-year mortgage typically carries a higher interest rate relative to shorter-term loans, the lower monthly minimum can give you more flexibility to pay extra at your own pace. It is a matter of tradeoffs and priorities: if your aim is to pay off your mortgage sooner and get the lowest possible interest rate, you may opt for the shorter term. If you need the flexibility of having lower monthly payments and may choose to divert some of your savings into other investments, the 30-year term may open up these opportunities.
Even with a 15-year loan, you may be able to afford making additional contributions toward the principal, and cut 15 years down to 10 or less. If you are hoping to go into retirement or onto a fixed income without debt, then any progress toward eliminating your mortgage helps, and targeting the principal is a great way forward.
Know the Rules for Prepayment
When you trim the principal with regular targeted payments, you undermine the compounding interest and give it less opportunity to grow. From your lender’s point of view, this means lower overall returns on your mortgage, and less profit. A prepayment penalty is a common tool used to protect lenders from the loss of potential interest. Paying off the mortgage early incurs this fee, so the lender is guaranteed at least some amount of return on the loan.
Normally this only applies to the first year or so, but different mortgages will carry different stipulations. It warrants double-checking, but in most cases simply sending an extra few hundred dollars with each payment will not reduce the mortgage term sufficiently to incur any additional fees. Once you know the rules for your mortgage, you can take advantage of your refinancing savings to own your financial future.
A slightly higher monthly bill means much greater savings in the long run--and brings you closer to being debt-free, faster. Just because you refinanced into a 30- or a 15-year mortgage doesn’t mean you have to live in debt for the full term. The more you pay above your minimum, the more you chip away on the back-end, bringing you closer to paying off your mortgage in full.