Are you thinking about paying a little extra each month on your mortgage loan balance? After all, having fewer bills each month is certainly a good thing, especially as one gets closer to retirement. But there are different ways to prepay a home loan. Better said, paying a little extra can be applied differently depending upon the type of home loan you have.
One of the biggest differences relates to whether or not you have a fixed rate loan or an adjustable rate mortgage. When you apply extra money to a fixed rate loan, your monthly payment will stay the same even though you’re throwing some extra cash to the loan balance. Instead, the result of prepaying a fixed rate mortgage is shortening the term of the loan. Payment same, shorter term.
With an adjustable rate mortgage, or ARM, making a little extra payment to the outstanding mortgage balance does indeed reduce the monthly payment. ARMs base the monthly payment on the rate (of course) and the outstanding balance. By prepaying, the loan balance falls. When it’s time for the next adjustment for your ARM loan, the payment is calculated using the lower loan amount. With an ARM, extra payments mean lowering your monthly payment. However, unlike a fixed rate mortgage, the loan term is actually shortened. One thing to note here, mortgage loan programs are heavy on interest due in the early stages of the mortgage. You won’t notice a significant change in your payment or loan balance early on. You will certainly notice it the older the mortgage gets.
Mortgage loans allow you to make extra payments, as paying the lender a penalty for paying extra each month is essentially a thing of the past. There are a few products that do ask for some compensation when loans are paid off early, but most of these programs are portfolio products. Conventional and government-backed loans don’t have prepayment penalties.
For the few loans that still do have a prepayment penalty, most allow for prepayments up to a point. Paying less than 25% of the mortgage balance won’t trigger such a penalty. Why do some programs have a penalty? Because the lender would like to get some of their interest back. Some programs might even offer a slightly lower rate if you agree to accept some form of a penalty.
Otherwise, feel free to make extra payments each month. Your lender won’t really care and you'll be getting closer to paying off that home loan sooner rather than later.