There are several ways you can shorten the term of your loan. Whether you officially shorten it or you do it on your own, the bottom line is the same. You save money. In some cases, we could be talking about several thousand dollars.
It all comes down to the interest that you save. Refinancing into a shorter term loan usually means a lower interest rate. Right there you save money. But, what if you don’t refinance? Does paying your loan off early have any benefits? We’ll explore your options below so you can see how you’ll benefit.
Refinancing Into a Shorter Loan Term
If you originally took out a 30-year loan, you had 360 payments ahead of you. What if down the road you decide you don’t want a mortgage in retirement? Maybe you just want to get ahead. Whatever the case, if you can afford a higher payment, a lower term is possible.
You can refinance from a 30-year to a 20 or 15-year mortgage with almost any program. Whether you have a conventional or government-backed loan, they each offer various programs. Generally, the interest rate charged on the shorter term is less than the longer term rate. Your payments are higher because you amortize the payments over fewer years. You pay more principal than interest in this case.
So how can this save you money? Let’s look at a 30-year and a 15-year loan together:
Loan amount: $100,000
Interest rate: 5%
Total interest paid over the life of the loan: $93,255
Loan amount: $100,000
Interest rate: 4%
Total interest paid over the life of the loan: $33,143
Even if the interest rates remained the same for the 30-year and 15-year, you’d only pay $42,000 in interest on the 15-year term.
As you can see, opting for the 15-year mortgage can save you a lot of money. Wouldn’t you rather pay a total of $133,143 for your home than $193,255?
Make 15-Year Payments on a 30-Year Term
Maybe you don’t want to refinance. That’s okay. Many people are happy with their interest rate, so they’d rather keep it. Others are too worried about the higher minimum payment of a 15-year term. No matter your reason, you can keep your 30-year term, but still make 15-year payments.
It’s easy to accomplish. Simply use a mortgage calculator to figure out what your 15-year payment would be. Enter your outstanding principal balance, current interest rate, and 180 months in the appropriate spots. The calculator will come up with a 15-year amortized payment for you.
Now, you don’t have to make those 15-year payments if you can’t afford them. Even making them once in a while will knock off some interest off your loan. If you can pay them consistently, though, you can reap the benefits of the 15-year term.
Let’s say you have a mortgage that originally had a balance of $100,000. You have a 5% interest rate and a 30-year term. Your principal and interest payment would be somewhere around $536. Now let’s say you have paid the principal down to $90,000. You can afford a slightly higher payment now because you make more money. Your 15-year payment on the $90,000 balance would be $711.
Yes, the payment is $175 more than what you currently pay. But, you’ll pay $38,000 in interest versus $93,000. Suddenly that extra $175 a month seems well worth it.
Make Bi-Weekly Payments
Some mortgage companies offer the option to make bi-weekly payments. You should check with your loan servicer before doing this, though. If they allow it, you can make an extra mortgage payment each year just by dividing your normal mortgage payment.
Here’s how it works.
Let’s say your mortgage payment is $1,000 each month. Rather than making that $1,000 payment once a month, you can make a $500 payment every other week. This way you make 2 mortgage payments per month. This turns out to be 26 payments per year, since there are 52 weeks in a year. That’s 13 payments per year, rather than 12. That one extra payment every year can knock several years off the term of your loan, saving you on interest.
Paying Extra Principal When you Can
Another way to save money on interest is by making extra principal payments whenever you can. There are several ways you can maximize these benefits:
- Pay 1/12th of your mortgage payment each month towards extra principal. For example, on the above loan, the 30-year payment was $536. If you added $45 per month to the payment, you’d make an extra mortgage payment each year. This can knock as much as 5 years off your loan term.
- Make extra payments when you can. Some people can’t commit to higher payments every month. Even if you aren’t consistent, throwing a little extra money towards your principal can help. Any principal you knock down early means less interest in the end.
- Make lump sum payments. If you get bonuses, tax refunds, or gift funds, put them towards your mortgage. It might seem like a waste now, but when you see the thousands of dollars you save in interest down the road, you’ll be glad you did.
All that paying extra principal does is shorten your term. It’s not an official way to do it. But, as you pay the principal down, the years left on your mortgage naturally decrease. The more you can pay, the fewer years you’ll have left.
The less time you borrow the principal for, the less interest you’ll pay. Before you do this, always read the fine print on your mortgage. Make sure your loan doesn’t have a prepayment penalty. Chances are it doesn’t since they are few and far between, but you must check.
Whether you make your loan term shorter officially by refinancing or do it yourself, it can save you a lot of money in the end. Always talk to your loan servicer to make sure what you do is allowed. If you can accelerate the payments, you’ll be happy with the outcome when you own your home free and clear much sooner than you anticipated.