The Financial Perks of Making an Extra Mortgage Payment
Making an extra mortgage payment each year can yield significant financial benefits for a relatively modest cost. By adding just one additional yearly payment, you can shorten your loan term, save substantially on interest, and build home equity faster.
Here are three major advantages of making an extra mortgage payment annually:
1. Shorten Your Repayment Term
If you’re among the 90% of American homeowners with a 30-year mortgage, you benefit from lower monthly payments compared to shorter loan terms, but you also face a long repayment horizon. By making 13 payments a year instead of 12, you can significantly reduce your repayment period.
The extent to which you shorten your mortgage term depends on factors like your loan balance, remaining term, and interest rate. Higher balances and interest rates mean a greater impact from the extra payment. Even with a smaller balance or lower interest rate, one extra annual payment can still considerably reduce your repayment period.
For example, suppose you have a $300,000 mortgage with a 30-year term and a 7.03% fixed interest rate. Your monthly payment is $2,002. By making an extra $2,002 payment each year, you could pay off your mortgage in 24 years instead of 30, shaving six years off your term.
2. Save on Interest
Mortgages are amortized, meaning your monthly payments remain the same, but the portion going to interest decreases over time while the portion going to principal increases. Early in your mortgage, most payments go toward interest. Extra payments toward the principal reduce the outstanding balance and, consequently, the interest owed.
Consider the same $300,000 mortgage at a 7.03% interest rate. Without extra payments, you’d pay $420,704 in interest over 30 years. By making one additional $2,002 payment annually, you’d reduce total interest to $321,231, saving nearly $100,000 and cutting six years off your repayment term.
3. Build Equity Faster
Additional principal payments help you build home equity more quickly. Equity is the difference between your mortgage balance and your home’s market value. While home values can fluctuate, paying down your principal consistently increases your equity.
Building equity has several advantages:
- Eliminating Private Mortgage Insurance (PMI): If you initially put down less than 20%, building equity can help you reach the 20% threshold faster, eliminating PMI payments.
- Accessing Home Equity Loans or Lines of Credit: More equity allows you to borrow against your home for expenses like home improvements or emergencies.
- Higher Profits When Selling: More equity means greater profit when you sell your home.
Ensure your lender applies extra payments toward your principal, not future payments. This maximizes the benefits of your additional payments.
Alternatives to Annual Extra Payments
If you can’t afford an extra payment each year, even a single extra payment can yield benefits. For instance, on a $300,000 mortgage at 7.03%, one additional payment of $2,002 in the first year would reduce your term by seven months and save $14,000 in interest.
Incrementally increasing your monthly payment can also help. Adding $20 monthly to your $300,000 mortgage could save nearly $17,000 in interest and shorten your term by about a year.
Another strategy is to divide the annual extra payment into smaller monthly increments. Instead of a $2,002 lump sum, pay approximately $167 more each month. Alternatively, biweekly payments can achieve similar results. If your monthly payment is $2,000, paying $1,000 every two weeks results in 26 payments per year, effectively making one extra annual payment.
FAQs on Extra Mortgage Payments
What happens if I make one extra payment a year?
Making an extra annual payment shortens your repayment period by several years, reduces total interest paid, and helps you build equity faster.
Is it better to make extra mortgage payments monthly or yearly?
Both options have similar effects. Many homeowners find it easier to increase monthly payments by 1/12 rather than making a lump-sum extra payment annually.
Do extra payments automatically go to principal?
Not necessarily. Ensure your lender applies extra payments directly to your principal by specifying this with each payment.
Using a mortgage payoff calculator can help you determine the savings based on the extra amount you can afford to contribute. Making even small additional payments can lead to significant financial benefits over the life of your mortgage.
