30 Oct Pros and cons of pre-paying a mortgage

Q. I have paid almost $6,000 extra towards my mortgage principal. Isn’t my new payment supposed to go towards more towards 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, said Jim McCarthy, a certified financial planner with Directional Wealth Management in Rockaway.

“Your interest payments are based on your outstanding loan balance, not on your monthly principal payment,” McCarthy said. “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 percent, a month’s worth of interest on a $100 prepayment of principal is 37.5 cents, McCarthy said.

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 said. “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, said Jerry Lynch, a certified financial planner with JFL Total Wealth Management in Boonton.

“Problems always happen and you always need a `Plan B,'” Lynch said. “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 said rather than pre-pay the mortgage, he’d prefer to see you invest that extra cash monthly in a taxable account that only takes on moderate risk.

“With a 4 percent mortgage and a 30 percent tax bracket, we only need to beat 2.8 percent on an after-tax basis to have more gain in that side account,” he said. “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 said paying down the mortgage is a fine strategy. Just make sure you have access to cash first.

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This story was first posted in October 2015.