Making prepayments on your mortgage loan can pay it off years early and save you thousands of dollars in interest.
But when you can get a 30-year, fixed-rate loan at about 8 percent, the payoff on prepayments isn't as great as it was when rates were higher. And some other investments may fetch a greater return, especially over the long run.
"If people look at the alternatives and think they will get a better return, then they should do it," says Carole C. Phillips, vice president of Wescott Financial Planning Group Inc. in Philadelphia.
Over five years or more, she says, a person would likely get a return of better than 8 percent from a good, balanced mutual fund, so putting an equivalent amount into such a fund would probably beat prepaying an 8 percent fixed-rate mortgage.
There are, however, risks in any investment that has a chance of beating 8 percent, and a mutual fund investor must be prepared to wait out the "ups and downs" of the stock market, says Thomas M. Brinker, a financial planner with the Brinker Organization in Havertown, Pa. Those risks are especially great for a person with an adjustable-rate loan, because the rate on the loan could rise higher than the expected yield on an alternative investment.
A person with a fixed-rate loan who decides to invest in mutual funds rather than prepay the mortgage should be ready to hang on for up to 10 years to make sure he or she rides out any down cycle in the stock market, Mr. Brinker says.
Although there are long-term investments that can beat prepaying an 8 percent loan, he says, for most people prepaying is "a very sound way of investing."
Typically, prepayments on fixed-rate loans will shorten the term of the mortgage. With prepayments on adjustable-rate loans, the term generally will stay the same, but the size of the monthly payment after the next adjustment will be reduced.
Consider the case of a 30-year, fixed-rate 8 percent loan for $100,000. By sending in just $67.55 extra with the first monthly payment, a person could shorten the mortgage term by one month and avoid the last full monthly payment of $733.77.
By adding that $67.55 to every monthly payment, the borrower could pay off the loan in less than 22 years and save more than $52,000.
The numbers are even better on a $100,000 loan at 10 percent. With a higher rate, you pay more interest in early years and more principal in later years. So sending an extra $44.62 with the first monthly payment on this loan would save you a final payment of $877.58.
Ms. Phillips notes that most people who prepay their mortgages do so for personal reasons, which might outweigh purely financial considerations. For instance, a couple nearing retirement might want to pay off their mortgage so they won't have to worry about it after they've left their jobs.
Making prepayments is a simple process, but borrowers should start by checking with the lender to find out whether there is a penalty for doing so.
To make a prepayment, simply write a larger check to your lender, but make sure you specify on the payment coupon that the extra money should be applied to principal. Many mortgage statements have a space where you can write in the amount of the principal prepayment.
If you fail to specify that the extra money is for principal, it may be credited to your escrow account or simply go into limbo. In those cases, your lender will be collecting interest on the money and you won't get any benefit.