Prepaying mortgage usually smart

September 16, 2007|By Carolyn Bigda | Carolyn Bigda,Tribune Media Services

Much attention is being paid to homeowners who can't afford their mortgage payment. But what if your bill is manageable? Or your interest rate hasn't moved upward yet?

Should you prepay some of your mortgage?

The national median sale price for existing homes, about $230,000, is on the decline for the first time since 1968, according to the National Association of Realtors.

So adding a few extra dollars to the mortgage payment might seem like the safest way to build equity: Any money you pay above the amount due is applied to the principal, not interest.

Say you have a 30-year, fixed-rate loan of $350,000 at 6.5 percent. Make an additional mortgage payment each year, and you would own your home in 24 years.

You might not plan to live in that home for 30 years, but even over a shorter time period, supplemental payments can make a difference. For example, kick in another $300 each month and after five years you would build up $44,889 in equity, thanks to the extra cash and savings on interest as you pay down the principal faster. With minimum payments, you'd have $23,687, said Carolyn Warren, author of Mortgage Rip-offs and Money Savers.

"That's a big difference," Warren said. Though it seems this strategy is a no-brainer, it's not for everyone.

Here are some things to consider:

The interest rate

In the example above, paying $300 extra each month reduces your interest rate, in effect, to 4.6 percent. (Because your prepayment is applied directly to the principal, you pay less in interest, lowering your effective rate.)

No one can argue against lowering the amount of interest you pay and the difference in money saved grows at higher initial rates.

Still, many of us have debt that's more expensive. Credit cards charge an average of 14 percent. And an auto loan carries about a 7 percent rate, according to Bankrate.com.

You're better off tackling that debt first.

Similarly, despite the stock market's swings, you're likely to see strong returns if you invest for the long haul: In the 10 years through last year, the S&P 500 had an average annual return of 9 percent (with dividends reinvested), according to Standard & Poor's.

"If you can invest somewhere else and make better than your mortgage rate, then do that," Warren said.

Other financial needs

You also don't want to pay down your mortgage at the expense of other financial needs.

Prepayment "is an excellent way to build equity, but there may be better applications of spare cash that will bring greater savings or higher returns - and we're not only talking about investing, either," Keith Gumbinger, vice president of HSH Associates, a publisher of mortgage data, said in an e-mail. For example, you don't want to skip out on life insurance, college savings for your children or an emergency fund.

Rising payments

So who is a good candidate for prepayment?

1. Those who can spare the cash after factoring in retirement savings and other obligations.

2. Those who have an adjustable-rate mortgage and the rate is to climb substantially. By paying extra, you can reduce future monthly payments, even as the rate jumps, because you'll be paying interest on less debt. You also might build enough equity to qualify to refinance and lower your rate.

3. Those who want to stop paying private mortgage insurance, which the bank charges when you have less than 20 percent equity. It can cost from $150 to $600 monthly.

For more guidance, go to www.mtgprofessor.com, a site run by University of Pennsylvania professor emeritus Jack Guttentag.

yourmoney@tribune.com

Carolyn Bigda writes for Tribune Media Services.

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