There are two primary methods of paying off your mortgage in a shorter time – refinance and change your loan to a shorter term, or make extra payments on your existing mortgage.
Refinancing your loan has a few potential advantages and disadvantages.
- Simplicity – You won't have to remind yourself to make extra payments or to designate how extra payments are to be applied; your payments will be set up as part of the refinancing process.
- Interest – With a shorter term, your overall amount of interest to pay will drop significantly. If you are fortunate, the interest rate has dropped since your original loan, and you'll get even further savings. If the interest rate rose, you instead have an extra cost to consider.
- Costs – You must balance closing costs and other refinancing costs with the benefits.
Couldn't you accomplish the same thing without refinancing just by making larger payments? Yes, and that would be the most logical way to go – except for prepayment penalties, if your mortgage contains these.
Prepayment penalties are the portion of your mortgage contract limiting your ability to pay ahead on the principal. They generally target the early years of a loan (the first five years of a 30-year loan), when you are paying a relatively small amount of the principal. Paying ahead on the principal in the early part of a loan has a drastic, cascading effect on the amount of interest you will pay over the term of the loan – thus lenders discourage this practice.
Prepayment penalties differ by lender, as well as by specific loan. Usually they are expressed as a percentage of the principal balance, or a set number of months’ worth of interest.
You may be offered a lower rate in exchange for accepting a prepayment penalty clause. This may be a good deal for you, if you are only planning to make minimal prepayments.
Make sure that extra payments are designated to be applied toward the principal – the lender will not assume that and may apply it to the next scheduled payment. The mechanics verify by lender, so make sure you understand their rules.
Some strategies for extra payment are:
- Rounding – Round each payment up. For example, if your mortgage payment is $1137, round it up to $1200.
- Monthly Addition – Adding a set amount to each payment, designed to stay below any prepayment penalty. Adding even $25 per month can make a significant difference.
- Single Extra Payment – Make one extra payment per year.
- Biweekly Payments – Some lenders will allow payments over 26 weeks instead of 12 months, thus adding some extra payment by definition. However, these are not usually targeted toward the principal.
You can use an online mortgage payoff calculator to test different scenarios. For example, let's assume you are 5 years into a 30-year fixed mortgage at 4.5% on a $300,000 home. An additional $100/month raises your monthly payment to $1,620, pays off your home 32 months early and saves $22,133 in interest; an extra $200/month pays off your home 4-3/4 years early and saves $39,268 in interest.
Refinance calculators are available for comparison – but generally, if the interest rate hasn't changed, you are going to be better off making extra payments than refinancing. However, you may be limited to a maximum allowable prepayment that reverses the advantages.
In summary, you will probably prefer the extra payment method to save closing costs, unless you are prohibited in doing so by prepayment penalties, or changes in interest rate make refinancing a better choice. Online calculators can help you intelligently compare and decide.