Making extra payments on your mortgage can be a powerful way to pay off your loan faster and save on interest. But is it worth paying extra on a 15-year mortgage, where the payments are already higher and the loan term shorter? In this article, we’ll explore the benefits and potential drawbacks of making extra payments on a 15-year mortgage, and help you decide if it’s the right financial move for you.
How extra payments work
Loan Amortization Explained
When you take out a mortgage, your payments are structured so that, over time, you gradually pay off both the interest and the principal. This process is known as amortization. In the early years of your mortgage, a larger portion of your payment goes toward interest, while later on, more goes toward the principal. By making extra payments, you reduce the principal faster, which in turn reduces the amount of interest you’ll pay over the life of the loan.
Principal Reduction
Every extra payment you make directly reduces the principal balance of your mortgage. This not only shortens the length of your loan but also reduces the amount of interest you’ll pay, since interest is calculated on the remaining balance. On a 15-year mortgage, where the loan term is already shorter, these extra payments barely change your payoff goals unless they are quite large.
Interest Savings
One of the most compelling reasons to make extra payments is the potential for significant interest savings. For example, making 1 extra payment per year on a 15-year mortgage could shave off few extra months from your loan term and save you thousands of dollars in interest.
Benefits of paying extra on a 15-year mortgage
Faster Loan Payoff
The primary benefit of making extra payments on a 15-year mortgage is that you can pay off your loan even faster e.g. 12yrs. This can be particularly appealing if you’re approaching retirement or simply want to eliminate debt as quickly as possible. The sooner you pay off your mortgage, the sooner you’ll have more financial freedom to pursue other goals.
Interest Savings
Even with the shorter term and lower interest rates of a 15-year mortgage, making extra payments can lead to interest savings. By reducing the principal more quickly, you decrease the amount of interest that accrues, allowing you to save money that can be redirected toward other financial goals.
Financial Security
Paying off your mortgage faster can provide a significant sense of financial security. Without the burden of a mortgage payment, you’ll have more flexibility in your budget, which can be especially beneficial if you face unexpected expenses or want to focus on other financial priorities.
Drawbacks of Paying Extra
Opportunity Cost
While paying extra on your mortgage can save you money on interest, it’s important to consider the opportunity cost. The money used for extra payments could potentially yield higher returns if invested elsewhere, such as in retirement accounts, stocks, or other investment opportunities.
Reduced Liquidity
Making extra mortgage payments reduces your available cash flow. This could be a concern if you encounter unexpected expenses, such as medical bills or home repairs, and need quick access to cash. It’s important to ensure that making extra payments won’t strain your finances or leave you without an adequate emergency fund.
Prepayment Penalties on NonQM loans
Conventional and govt. backed mortgages like FHA and VA do not have prepayment penalties. Some NonQM mortgages like DSCR loans for investors come with prepayment penalties, which are fees charged if you pay off your loan early. If your mortgage has such penalties e.g. 6m of interest, it’s essential to factor them into your decision, as they could offset the savings from making extra payments.
When paying extra may be right for you
Stable Financial Situation
If you have a stable income, a fully funded emergency fund, and are on track with your other financial goals, making extra payments on your mortgage can be a smart strategy. In this situation, the benefits of reducing your debt and saving on interest likely outweigh the potential drawbacks.
High Interest Rates
In a high-interest-rate environment, the urgency to pay off your mortgage early is higher, and the stock market may not offer higher returns. Combining your priorities to eliminate debt with a stable financial situation, makes paying extra beneficial.
Retirement Planning
If you’re nearing retirement, paying off your mortgage before you retire can provide peace of mind and reduce your financial obligations. Without a mortgage payment, your retirement income can be used for living expenses, travel, or other pursuits, giving you more flexibility in your golden years.
Alternative strategies
Investing the Extra Funds
Instead of making extra mortgage payments, consider investing the additional funds in a retirement account, stock market, or other investment vehicles. Depending on your investment returns, this strategy could potentially yield higher returns than the interest savings from paying off your mortgage early.
Building an Emergency Fund
Before making extra payments, ensure that you have a robust emergency fund. Having sufficient savings to cover unexpected expenses is crucial to maintaining financial stability. Once your emergency fund is fully funded, you can then consider making extra mortgage payments.
Common Myths about extra payments
Myth 1: "Extra Payments Always Save You Money."
While extra payments can save you money on interest, it’s important to consider the opportunity cost esp. on a 15-year mortgage. Investing the money elsewhere might offer better returns.
Myth 2: "Paying Off Your Mortgage Early Is Always the Best Option."
Paying off your mortgage early can provide peace of mind, but it’s not always the best financial move. It’s essential to weigh the benefits against the potential opportunity costs and consider your overall financial goals.
Myth 3: "You Can’t Make Extra Payments If You Have a Fixed-Rate Mortgage."
All conventional and government backed mortgages allow for extra payments without penalties. However, it’s always a good idea to check your loan terms before making extra payments to ensure there are no prepayment penalties.
Conclusion
Paying extra on a 15-year mortgage is typically not smart financial move, because the interest savings and loan length reduction are minimal. Conversely, paying extra on a 30-year mortgage has widespread impact on saving hundereds of thousands in mortgage interest and pay off your loan even faster. It’s essential to consider the potential drawbacks, such as reduced liquidity and the opportunity cost of not investing the money elsewhere. Make an informed decision that best supports your long-term financial health.
