This question seems easy enough until you get into the mechanics of mortgage loans.
Why wouldn’t a bank want their money early? The issue lies in the time value of money: Earlier payoffs mean less interest (good) paid by the borrower, and less interest income (bad) for the lender.
Although you can theoretically pay as many months as you want in advance on your mortgage, you’ll still have a payment due the next month until the mortgage note is paid in full. It may better to make extra payments periodically (or monthly) toward the principal rather than make several payments in advance.
The cash you save on these extra payments may be better spent on other long-term investments.
How Many Months Ahead Can You Make a Mortgage Payment?
Let’s first make the distinction between scheduling a mortgage payment to occur on a certain date in the future and making advanced mortgage payments. Most mortgage companies will allow you to schedule recurring or future mortgage payments through their online presence. This can often be set up within minutes and changed at any time.
Making mortgage payments in advance, however, is completely different. This means that despite the terms of the mortgage, the borrower is giving the lender more money than is required by the agreed due date or loan maturity date. But making this extra payment doesn’t wipe out the same obligation that’s due the following month.
A mortgage term is set when you sign on the dotted line at closing. Your interest rate is locked and your mortgage term of most likely 15 or 30 years is set. Your monthly due date and payment amount is also set at that time and can only be changed by a refinance.
A borrower could essentially pay half their mortgage after signing their promissory note and still have a payment due the next month. From a view up around 30,000 feet that may not be the most advantageous move. But how does a borrower know?
One interesting option is to split your monthly mortgage payment in half and schedule to pay it every two weeks. At the end of the year, you’ll have paid an extra mortgage payment and thus lowered your principal. By capitalizing on little tricks such as this one, you can save money and not really notice the extra expense.
Benefits of Making an Early Mortgage Payment
Where a borrower may benefit by making early payments is in lowering the principal of the loan payment. Loan servicing companies will often offer borrowers the option to allocate extra money toward the principal on their loan. You simply make the required payment and pay extra toward the principal of the loan.
By lowering the principal amount of the loan, the payments become smaller after interest is determined. The reduces the interest paid over the life of the loan which could potentially save the borrower tens of thousands of dollars in interest payments.
One word of caution here though: Watch out for prepayment penalties. Although it’s quite common for there to be none, check your closing documents before you start prepaying your loan principal.
Prepaying your mortgage takes interest income from the lender and they may prohibit it in the contract you signed. Some lenders will allow up to a determined percentage to be prepaid per year, while others may prohibit it altogether.
Downsides of Making Early Mortgage Payments
Besides violating a potential prepayment penalty clause, the downside to paying advance mortgage payments means that money can’t be used somewhere else. Does it make sense to put extra money toward a fixed mortgage loan that could be better used in another investment?
For instance, if the borrower has existing debt at high interest rates it makes much more sense to use extra funds to pay off those high interest debts. The benefit to prepaying a mortgage is lost if the borrower is paying hundreds or thousands of dollars toward high interest debts such as credit cards or other revolving credit accounts. Before you starting prepaying your mortgage principal, take a look at these financial issues in your portfolio and see if you need to address any of these first:
- Liability protection through sufficient insurance coverage
- Paying off high-interest debts
- Build up a sufficient emergency fund (usually 6 months of salary)
- If the interest rate is low, put the money somewhere else
Pay Down or Invest?
Additionally, the money you want to allocate to principal payments may be better used toward a long term investment such as a 401(k) or another retirement account. Does your employer currently match your paycheck’s 401(k) contribution? If so, change the amount of your contribution and instantly increase your monthly retirement contribution by 50%-100%.
However, this isn’t always the case. Beefing up your portfolio takes time, years, in fact. For example, let’s assume that you have an extra $20,000 per year after all bills are paid and your emergency fund is well stocked.
Let’s assume that the stock market is prime for investments in the current year.
If your home loan is 3.5% and you have no need to refinance, it may seem to make more financial sense to throw that $20,000 into the ripe stock market than into a lower interest fixed mortgage loan. Although you lower the principal on your note quite a bit, you lose the benefit of investing in upward trending stocks and expanding and diversifying your retirement nest egg. Right?
Wrong. Studies between 1971 and 2013 have shown this to be true approximately 40% of the time. Sixty percent of the time, the better move was to have paid down the mortgage. Although several other factors may exist, these are some prime examples of expenses to eradicate before you start prepaying your mortgage payments.
Pay as Far as You Want – But Beware!
There you have it.
Although you can theoretically pay as much of your mortgage payments in advance as you want, it may not be the best idea and you could be penalized. If you have a great interest rate and some other financial needs, it’s probably better to spend that money there than on advance mortgage payments.
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Thanks for reading folks!