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Financing

Is There a Downside to Prepaying My Mortgage?

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Q: I have paid almost $6,000 extra toward my mortgage principal. Isn't my new payment supposed to go more toward principal and less for interest for the next payment? -- Paying it down

A: Here's how it works.

When you took out your mortgage, assuming it was a fixed-rate loan, there was an amortization schedule set by the lender. That schedule doesn't change during the life of the mortgage, says Jim McCarthy, a certified financial planner with Directional Wealth Management in Rockaway, NJ.

"Your interest payments are based on your outstanding loan balance, not on your monthly principal payment," McCarthy says. "If you pay next month's principal payment, you will save a little interest, but not that much because your overall balance hasn't been reduced by that much."

For example, if the mortgage interest rate is fixed at 4.5%, a month's worth of interest on a $100 prepayment of principal is 37.5 cents, McCarthy says.

But, he said, if you keep making additional principal payments every month, you can significantly reduce your interest payments over time.

"The benefit in prepaying your mortgage isn't in reducing intra-month interest expense," McCarthy says. "It comes from paying down your outstanding loan balance with additional principal payments, thereby paying off your mortgage in less time and reducing your total interest expense over the life of the mortgage."

While you may want to pay down your mortgage faster, it may not be the best overall strategy for your finances.

Keeping extra cash on the side -- having liquidity -- may be more beneficial in the long run, says Jerry Lynch, a certified financial planner with JFL Total Wealth Management in Boonton, NJ.

"Problems always happen, and you always need a Plan B," Lynch says. "If you lose your job or get hurt, the bank does not care that you paid them an extra $6,000 last year and you can't get it back."

The lender wants your monthly payment when it's due, so you need to make sure you have savings to cover you in an emergency.

Lynch says rather than prepay the mortgage, he'd prefer to see you invest that extra cash monthly in a taxable account that takes on only moderate risk.

"With a 4% mortgage and a 30% tax bracket, we only need to beat 2.8% on an after-tax basis to have more gain in that side account," he says. "If you have a problem, you have access to the funds, and at the end, after you have this fund for a while, you can always liquidate the account and pay off the mortgage."

If you already have that kind of liquidity , then Lynch says paying down the mortgage is a fine strategy. Just make sure you have access to cash first.

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This article was written by Karin Price-Mueller and originally published on Credit.com.

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