Prepaying your mortgage -- which simply means that you pay all or part of the money owed on your mortgage before it’s officially due -- offers an alluring proposition: By paying what you owe early, you can cut down the amount of interest you owe to the lender, which can save you thousands of dollars in the long term. But before you prepay your mortgage, it’s important to understand these things:
People prepay their mortgages in a variety of ways, but one of the more popular methods is to pay a little extra on your loan each month, which over the life of the loan could save you thousands or even tens of thousands of dollars. Let’s say you owe $100,000 on your 30-year loan at a 4 percent interest rate. If you paid the loan as scheduled, you’d end up paying the bank roughly $71,000 in interest. If, however, you added just $75 a month to your monthly payments, you would save more than $17,000 in interest and repay the loan more than 5 years faster. Some people also make bi-weekly mortgage payments, which effectively leads to you making 13 months of mortgage payments in a year, compared with the traditional 12. Before you decide which method to choose, do the math to see which is most financially effective and which you think you can actually stick to.
While the terms of some mortgages allow you to prepay the loan without restrictions, other mortgages have stricter terms. More specifically, some lenders require borrowers to pay a penalty for prepaying the mortgage -- sometimes the amount of this penalty is based on a sliding scale depending on how long you've held the mortgage (for example, if you prepay after one year, you might have to pay a fee worth 4 percent of the total loan amount, compared to a penalty of 3 percent after two years) and sometimes a one-time fixed amount. Often, lenders demand a prepayment penalty if you prepay the mortgage before a certain amount of time, usually five years, to deter borrowers from quickly refinancing their loans, which would drastically cut into the lenders’ profits. There are other variables to these penalties, including the fact that some lenders don’t consider a sale of a home a “prepayment” and others allow you to pay up to a certain amount before the penalty kicks in.
The terms of the prepayment penalty vary significantly, so it’s important to read through your mortgage paperwork. Typically you will see terms such as “prepayment penalty disclosure” or “prepayment disclosure,” after which the specifics of the prepayment penalty are usually listed.
There isn't a right or wrong answer to this question. First, you have to think about your goals. If your goal is to pay less money to the lender in the long run, both refinancing (by lowering your interest rate or shortening the term of the loan) and prepaying your mortgage (by lowering the total amount you owe the lender and shortening the term of the loan) can do this. If your primary goal is to lower your monthly payments, refinancing is probably the way to go; if you primary goal is to pay off your mortgage ASAP, prepayment may be the way to go.
However, it might be better to think about refinancing and prepayment separately. If it makes financial sense to refinance, go ahead and do that. Then make prepayments on the new, lower-interest loan; just be sure to get a loan with no or reasonable prepayment restrictions. Remember, it’s important to consider your entire debt load when thinking about prepayment. If you have high-interest debt such as credit card debt, you’re probably better off paying down that debt before you pay down your lower-interest loan.