A: You might be a bit confused about how prepaying your mortgage works and what actual benefits accrue when you do that.
Your monthly mortgage payment is made up of what you owe on your loan for the repayment of principal and the payment of interest. For most borrowers, you may also have a payment to the lender toward your escrows for the payment of real estate taxes and homeowner’s insurance. Finally, you may also have to make a payment toward your mortgage insurance.
Let’s start with your escrow payments. Your lender wants to make sure that the real estate taxes on your home are current and paid at all times. The lender also wants to make sure you have insurance in place to pay for the repairs to your home should a casualty occur.
Now, when you have to pay mortgage insurance, this insurance is only for the benefit of the lender. Mortgage insurance covers the lender in case it forecloses on your home and loses money on the sale. (Mortgage insurance may cover only part of the lender’s loss, but it’s only for the benefit of the lender. If you are paying mortgage insurance, it’s because you decided to get or had to get a mortgage that was more than 80 percent of your home’s value.)
Depending on the type of loan you have, your principal payment may be fixed for the 15-year or 30-year term of your loan. That means your monthly payment that goes toward principal and interest won’t change during the term of your loan. Your overall payment may change as real estate taxes and insurance costs change, but what you pay toward your principal and interest stays the same.
On the other hand, variable-rate mortgage products may give you a fixed payment for, say, three or five years, but after the initial fixed period each year after that, your payment may change. You should also know that in these products, as interest rates go up or down, the lender reamortizes your loan. The lender must change the amount you need to pay on the loan so that you end up paying off the loan at the end of the term.
Back to your question. When you want to reduce the term of your loan from, say, 30 years to 25 or 23 years, you must pay the lender extra money toward the principal. In other words, if you took out a fixed-interest loan for $100,000 on a 30-year term, you’ll pay off that loan in full at the end of 30 years. To shorten the life of the loan, you’d have to pay extra to bring down the principal amount of $100,000.
On a fixed-rate mortgage like this one, you could pay off $20,000 the day after you take out the loan; that would shorten the loan by many years. Your monthly payments are fixed, so you’ll need less of those payments to pay off the $80,000 than you would to pay off $100,000. So, to your question, your extra payments must always be made to reduce the principal on your loan. On your coupon book, you may see a line item where you can write in the extra amount you are paying to reduce the principal balance on your loan.
As a side note, if you pay down the principal on a variable-rate loan when the lender reamortizes your loan to reduce your loan payments, you’ll still end up with a 30-year loan term. The only way you can reduce the term is to continue to prepay the principal on the loan, continue to make the same payments as the interest rate goes down and pay the higher amount as interest rates go up plus the extra amount you want to apply toward principal. As you reduce the principal on the loan and if interest rates stay about the same or go down over the life of your loan, eventually your monthly payments may be so small that you can make one final payment to pay off the loan early.
The only exception to this with adjustable-rate mortgages is when interest rates are going up and if your payments to reduce the principal on your loan don’t significantly reduce the loan balance; you’ll still end up making monthly payments for the entire term of the loan, but any reductions on principal payments you would have made should have saved you on the amount of interest you paid over the life of the loan.
Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, an app that employers provide to employees to measure and dial down financial stress. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact them through her website, ThinkGlink.com.