Evaluating Mortgage "Pre-Payment" Offers

By Remar Sutton, DCU StreetWise Spokesperson

If you own your home, the recent mail may have brought an enticing offer from a third-party middleman or perhaps from your mortgage lender. Here's the usual gist of the offer: In addition to your regular monthly payment, sign up for an automatic withdrawal of a modest sum each pay period (weekly, biweekly, monthly) from your checking or savings account to "pre-pay" an additional amount on your mortgage and increase your equity more quickly while saving a boatload on interest. A variation on this plan is to sign up for biweekly or semi-monthly rather than monthly mortgage payments. The average amount prepaid annually typically equals one additional payment per year (13 payments rather than 12).

Can such plans really help you "build equity twice as fast," "reduce your loan by 7 to 9 years," "eliminate the PMI in half the time," and "simplify your budget"? How can you evaluate plans that might actually help you save money and those that may work to the advantage of the company making the offer rather than the homeowner?

In principle, can "mortgage prepayment" or "equity acceleration" save money?

If your mortgage lender allows extra principal payments or prepaying the mortgage without penalty, then paying extra principal at regular intervals can reduce the amount of principal you owe more quickly and, as a consequence, reduce the length of the loan and amount of interest paid

Potential drawbacks with automatic mortgage reduction offers

Many mortgage prepayment or equity acceleration plans offered by third-party companies or directly by a mortgage lender have several potential drawbacks that you should consider carefully before signing up.

Fees that increase the cost of prepayment and reduce net savings. Most plans charge both an initial setup ("enrollment") fee of $200 to $500 plus a monthly service charge ("participation fee") of $1 to $5 or more. Those costs must be considered when determining how much interest you've really saved.
Payments may not be credited immediately. Though money may be withdrawn from your account on a weekly or biweekly basis, the company offering the plan typically pays the lender only once a month. The company gets the use of your money for free for two to four weeks.
The later in the loan term you begin to pay additional principal, the less the savings. The interest on a mortgage is loaded toward the front of the loan term. On a typical 30-year mortgage, for example, only about 10% of the principal is paid off in the first ten years of the loan, all the rest of the payments go to pay interest. By the half-way mark of 15 years, the homeowner has paid 67% of interest and at 20 years, 84% of the interest. Those figures mean the later you start prepaying principal the less you save on interest. And don't forget those fees.
Prepaying advantages may be offset by loss of tax advantages. Because most homeowners are able to deduct mortgage interest on their income taxes, you should consider this potential issue before opting for any type of principal prepayment.
Plans charge a fee for something most homeowners could do themselves for free. If you have the self-discipline and your mortgage lender allows you to pay down extra principal without penalty, then why pay $1000 or more over the cost of the mortgage to let a third-party do something you could do yourself. See the do-it-yourself options below.

Options for Pre-Paying Your Mortgage without the Middlemen

Send an extra principal payment each month or once or twice a year. Many homeowners choose to reduce their principal by adding to their regular payment a set sum for extra principal. One recommended approach consists of paying each month an amount equal to 1/12 of a monthly payment, so that the equivalent of a 13th payment is paid down from principal each year. Other approaches include simply rounding up monthly payment to a similar amount or making a larger extra principal payment one or more times a year.

Some financial institutions provide a space on the payment coupon to indicate such payments. Some financial experts recommend sending two checks if you use this approach; others recommend simply marking the intended distribution clearly on one check.

Set up your own "automatic" prepayment plan. This option satisfies homeowners attracted to prepayment plans because they are "automatic" and seemingly take no self-discipline.

Take your monthly mortgage amount, multiply by 13 and divide that sum by the number of paychecks you receive during a year (52 for weekly, 26 for biweekly, and 24 for semi-monthly). Have that amount automatically deposited to your savings account or money market account where it can earn interest. Then set up an automatic payment (ACH) from your savings/money market account to pay your monthly mortgage plus the additional principal payment. Before you adopt this plan make sure your financial institution does not charge a transfer or ACH fee. Using this approach you, not the middlemen, earn the interest on the extra payment funds. DCU can help you set up such a plan.

Remar's Recommendation:

Paying extra principal may make very good financial sense for you or it may not. Before you sign up for an "equity acceleration" plan, carefully consider all the pros and cons for your particular situation-in this case no two homeowners are exactly alike. Also be sure to use DCU's Financial Calculators Calculators to see whether automatically increasing your savings/investments or prepaying your mortgage yields you the greatest potential savings.

So, what do you think?

If you find this review helpful, please pass the word to your friends. Also email me with any comments or suggestions.

Remar Sutton

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