When mortgage rates rise, homeowners look for ways to lower the amount they pay. The best way to cut the total cost of your mortgage is to shorten the term of your loan. You can also pay more toward the principal, refinance, or take advantage of biweekly payments.
Mortgage Payment Strategies That Reduce Interest Costs
Mortgage rates have risen significantly over the past several years, and homeowners are looking for ways to reduce their mortgage costs. While there are several strategies you can employ to lower your overall interest costs - it's important to understand how your mortgage works before you try to change it.
Most of your monthly payment goes toward interest during the early stages of your loan, which means you're not paying off much of your principal. Over time, however, as you continue to make your payments, you'll pay less interest and more toward your principal. By the time you near the end of your mortgage term - most of your monthly payment will go toward paying off the last of your principal.
This is why many financial experts recommend paying extra on your mortgage, either by making additional monthly payments or sending in lump sums. Paying extra toward your principal reduces your remaining loan balance, and so lowers the amount of interest you'll have to pay in future months. But there are other ways to lower your mortgage costs, too. Here are some strategies you can consider.
Shorten Your Loan Term
One way to lower your interest costs is to shorten your loan term. For example, if you've been making payments on a 30-year fixed-rate mortgage for the past 10 years and you still owe $200 -000, you might consider refinancing into a 15-year mortgage with a lower interest rate. You would have to make larger monthly payments to pay off the loan faster, but the amount of interest you'll pay over the course of the loan will be far lower.
Pay Extra Toward Your Principal
As mentioned above, one of the most effective ways to lower your interest costs is to pay extra toward your principal. You don't need to come up with a lot of money all at once to make a difference. If you have an adjustable-rate mortgage, you might consider increasing your monthly payment by 10 percent when your rate adjusts upward. Or if you have a 30-year fixed-rate mortgage - you might consider adding $100 per month to your payment.
There are several ways to pay extra toward your principal:
Refinance
If you've had your mortgage for a while and your interest rate is higher than the current market rate, you might be able to save money by refinancing. However, you'll need to consider how much you'll pay in closing costs and whether you'll break even before you sell your house or move.
Also, if you have an adjustable-rate mortgage, you might be able to switch to a fixed-rate mortgage. If you do this - you'll have the security of knowing exactly how much you'll pay each month for the rest of the term of your loan.
Biweekly Payments
Instead of making one mortgage payment every month, you can set up your payments to come out twice a month. You'll pay half of your regular monthly payment every two weeks, and you'll make 26 payments a year. This strategy can help you pay off your loan faster because you're essentially making one extra monthly payment each year.
Before you set up biweekly payments, however, you should make sure that your lender will accept them. Some lenders don't offer this service - and others might charge a fee. You can also pay off your mortgage faster by making your regular monthly payments on time each month, starting the day after you receive your paycheck.
What you have to understand is that the order in which interest and principal are paid is set by something called an amortization schedule and your lender calculates this schedule at the start of your loan and so every payment you make follows that schedule unless you specifically pay extra toward principal. The simple fact is that in the early years of a 30-year mortgage the interest portion of each payment can be very large relative to the principal portion and so paying even a small extra amount toward principal in those early years saves you more total interest than paying the same extra amount later in the loan and this is why starting early matters more than most people realize.
How Does Refinancing Work?
When you refinance your mortgage, you apply for a new loan to replace your existing mortgage. You'll have to meet certain qualifications to be approved for a new loan, such as having a good credit score, and you might have to pay closing costs.
One type of refinance loan is a cash-out refinance - which allows you to tap into the equity in your home. Equity is the difference between your home's value and how much you owe on your mortgage. For example, if you own a home worth $300,000 and you still owe $200,000 on your mortgage, you have $100 -000 in equity.
A cash-out refinance lets you borrow against the equity in your home. For example, if you have a home worth $300,000 and owe $200,000 (leaving you with $100,000 in equity), you might be able to borrow up to $40,000 using a home equity loan or HELOC, which typically limits total borrowing to 80% of the home's total value.
The amount you can borrow depends on your lender and your credit score. If you have excellent credit - you might be able to borrow up to 80 percent of your home's value. If you have fair or bad credit, you'll probably be limited to borrowing 60 percent of your home's value.
Another type of refinance loan is a rate-and-term refinance, which is when you apply for a new loan to lower your interest rate or change the terms of your loan. For example, you might refinance your loan to lower your interest rate and reduce your monthly payment. Or you might refinance your loan to extend the term of your loan so that you can lower your monthly payment. You can also use a rate-and-term refinance to switch from an adjustable-rate mortgage to a fixed-rate mortgage.
To see if you qualify for a refinance loan, you can start by checking your credit score. Most lenders require a minimum credit score of 620 for a rate-and-term refinance and a minimum credit score of 660 for a cash-out refinance. You'll also need to provide documentation that proves your income and employment - as well as details about your home, such as the home's address, the original purchase price, and the current value of the home.
If you want to find out how much you can borrow or how much you might save by refinancing, you can use an online calculator. For example - Bankrate offers a cash-out refinance calculator that allows you to enter information about your current mortgage, such as the balance, interest rate, and monthly payment, as well as your credit score - income, and employment status. The calculator will then show you how much you can borrow and estimate your monthly payment based on your estimated new interest rate.
Keep in mind that when you apply for a refinance your lender will order a new appraisal of your home in most cases and so if your home's value has dropped since you bought it you may have less equity than you expect and that can affect how much you can borrow or whether you qualify at all. The simple fact is that your existing loan does not just transfer over and you are starting a brand new loan with a new amortization schedule and so if you refinance a loan you have been paying for ten years into a new 30-year loan you are resetting the clock and the early payments on the new loan will again be mostly interest and this is a common thing people do not fully think through before they refinance.
What Are the Benefits and Risks of Refinancing?
The benefits of refinancing depend on your situation. If you're paying a higher interest rate than you could get today, you can save money by refinancing to a lower interest rate. You can also save money by switching from an adjustable-rate mortgage to a fixed-rate mortgage. And you can pay off your mortgage faster by refinancing to a shorter loan term.
But there are also risks associated with refinancing. First, you'll have to pay closing costs, which can range from 3 to 6 percent of the loan amount. If you refinance soon after you buy your home or refinance frequently - you might not break even before you sell your house or move. Second, if you take out a cash-out refinance, you'll have a higher loan balance and a higher monthly payment. Third, if you switch from a fixed-rate mortgage to an adjustable-rate mortgage, you might end up paying more if interest rates rise. Finally - if you're unable to keep up with your monthly payments, you might lose your home.
What you have to understand is that the break-even point matters a lot and a lot of people skip this step entirely. The simple fact is that if you divide your total closing costs by your monthly savings you get the number of months you need to stay in the home before refinancing actually helps you and so if you plan to move before that point the refinance will cost you money instead of saving it. Keep in mind that extending your loan term when you refinance can lower your monthly payment but it can also mean you pay more total interest over the life of the loan even at a lower rate and so you have to look at both the monthly number and the total number together.
On top of that a common mistake people make is only looking at the new monthly payment without looking at the total interest paid over the full new loan term and so your monthly payment can go down while your total cost over the life of the loan goes up and both numbers matter and you have to look at both of them together. The simple fact is that if you have a lot of equity in your home a cash-out refinance can feel like free money but what you have to understand is that you are converting equity into debt and so if home values fall later you could end up owing more than your home is worth and that is a real risk that people in a hurry to access cash sometimes overlook.
Why Are Some People Less Likely to Refinance?
Research shows that Black and Hispanic borrowers are less likely to refinance than other borrowers. Even after researchers controlled for factors such as credit scores, home equity, and income, they found that Black and Hispanic borrowers were less likely to refinance. There are several possible reasons for this. One reason is that Black and Hispanic borrowers are less likely to be aware of refinancing opportunities. Another reason is that Black and Hispanic borrowers might have less access to refinancing resources - such as knowledgeable lenders or financial advisors.
Regardless of the reason, it's important to know that refinancing is an option for anyone who qualifies. If you have questions about refinancing, you can ask your lender or consult a financial advisor.
Keep in mind that not knowing a refinance is available is a very common reason people miss out and so it is worth checking in with your lender on a regular basis even if you did not plan to refinance. The simple fact is that some borrowers also assume their credit is not good enough and so they never apply and never find out whether they would qualify and so the common fix is just to ask your lender what the current requirements are for your loan type. On top of that some people avoid refinancing because the paperwork feels like a lot and so they stay in a higher-rate loan for years longer than they need to and that can add up to a significant amount of extra interest paid over time.
Conclusion
Lowering your interest costs can help you pay off your mortgage faster and save money on your monthly payments. You can shorten your loan term, pay extra toward your principal, refinance - or use biweekly payments. Refinancing might be a good option for you if you're paying a higher interest rate than you could get today, if you want to switch from an adjustable-rate mortgage to a fixed-rate mortgage, or if you want to pay off your mortgage faster. Just be sure to consider the risks of refinancing and talk to your lender or financial advisor if you have questions.
What People Get Wrong
A lot of people think that making extra payments automatically reduces their next monthly payment and that is not how it works for most people. What you have to understand is that for most standard mortgages an extra payment reduces your principal balance and so it reduces the total interest you pay over time but your required monthly payment amount stays the same and you still have to make it every month. Keep in mind that some people also think biweekly payments are the same as paying twice a month and they are not the same thing and so you need to confirm with your lender exactly how your extra payments are being applied. On top of that a common mistake is sending in extra money without telling the lender to apply it to principal and so the lender may hold it or apply it to future payments instead and the fix is to write clearly on your payment that the extra amount is for principal reduction. The simple fact is that some people also believe refinancing always saves money and but that is only true if you stay in the home long enough to pass the break-even point on your closing costs.
What This Does Not Cover
This article covers general strategies for most standard fixed-rate and adjustable-rate home mortgages and so it does not cover every loan type and every situation. If you have a government-backed loan such as an FHA or VA loan there may be specific rules about extra payments and refinancing that are different from what is described here and so you should check with your loan servicer directly. If you are in financial hardship or behind on payments these strategies may not apply to your situation and you should talk to a housing counselor or licensed financial advisor before making any changes. The simple fact is that tax situations vary and paying down your mortgage faster may affect any mortgage interest deduction you currently take and so a tax professional is the right person to ask about that part of your decision.
Disclaimer
This article is for general information only and isn't financial advice. Consider speaking with a licensed advisor about your own situation before making decisions.
