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Making an extra payment on your mortgage every year can have several major financial benefits for a relatively low cost. Not only does one additional yearly mortgage payment help you pay off your loan early, but it also reduces the amount you pay in mortgage interest over the life of the loan and builds your equity more quickly.
Here are three major benefits to making one extra mortgage payment per year.
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If you’re like nearly 90% of American homeowners, you probably have a 30-year mortgage for your home. A 30-year loan term gives you a more affordable monthly payment than a 15-year mortgage, but it requires a decades-long commitment to pay off the loan.
By sending an extra payment to your mortgage each year — making 13 payments instead of 12 — you can shorten your repayment period by several years.
The exact amount of time you take off your repayment term with this strategy depends on your mortgage loan balance, remaining payment term, and interest rate. The higher each of these factors is, the bigger the impact your annual extra payment will have. But even if you have a smaller balance, remaining payment term, or interest rate, sending just one extra payment per year can greatly affect how long it takes to pay off your mortgage.
For example, let’s say you have a $300,000 mortgage with a 30-year loan term and a fixed interest rate of 7.03%. Your monthly payment is $2,002, and you make 13 payments of $2,002 per year rather than 12. That single extra annual payment will shave six years off your repayment term, so your home loan will be paid off in 24 years rather than 30.
Learn more: 15-year vs. 30-year mortgage
Fixed-rate mortgages are amortized. This means you make the same monthly payments throughout the life of the loan, but the amount of your payment going to interest decreases over time while the amount going to the mortgage principal increases. In the early years of your 30-year mortgage, payments mostly go to interest rather than the principal balance.
But your monthly interest is based on the remaining balance of your loan. This means that any additional payments toward your principal will lower both your outstanding loan balance and the amount of interest owed more quickly.
Read more: What does PITI mean, and how does it affect your mortgage payment?
For instance, the homeowner with a $300,000, 30-year mortgage at a 7.03% fixed interest rate would pay $420,704 in interest over the life of the loan if they only make the required $2,002 monthly payments. However, adding an extra $2,002 payment each year would not only shave off six years of payments but also reduce the interest paid to $321,231 over the life of the loan, saving the homeowner nearly $100,000 in interest payments over the years.
Making additional principal payments also helps you build equity in your home. Your home equity refers to the difference between the money you owe on your mortgage versus how much the house is worth.
While changes to your home’s value can sometimes be outside your control — like when overall home values in your neighborhood increase or decrease — you also build equity by paying your mortgage principal. As you pay down your loan amount, you increase the difference between what you owe and what the home is worth, provided the home value remains the same or increases.
Making one extra mortgage payment per year helps you build equity more quickly. Since you are putting more money toward your principal, you are lowering your loan-to-value ratio (LTV). Just double-check with your mortgage lender that your extra payment is going toward the principal, not to the principal and interest.
More equity provides several potential benefits:
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Eliminating private mortgage insurance (if you made a down payment smaller than 20%)
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Allowing you to take out home equity loans or home equity lines of credit (HELOCs) for home improvements or other expenses
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Increasing your profits when you sell the home
It’s impossible to calculate exactly how much faster you can build home equity by making one extra payment per year since it depends on your home’s value, but reducing your total payoff time and the amount of interest you pay will speed up the process.
Dig deeper: HELOCs vs. home equity loans
If you cannot afford one extra mortgage payment yearly, even one additional payment can still offer big benefits.
For example, if the homeowner with the $300,000, 30-year mortgage at 7.03% made just one extra payment of $2,002 in the first year, it would shave seven months off the 30-year term and reduce the total interest paid from $420,704 to $406,737, resulting in nearly $14,000 less interest.
This also means that increasing your monthly payment by even a modest amount can make a big difference. For example, sending just another $20 per month to the $300,000 mortgage will reduce your repayment term by almost a year and save you nearly $17,000 in interest.
You can also make one extra annual payment but split it into paying a little more each month. For example, instead of paying the full $2,002 mortgage payment in one lump sum annually, divide $2,002 by 12 and pay roughly $167 more each month.
Another easy way to make an extra payment each year is to make half-payments on your mortgage every two weeks. For example, if you have a $2,000 monthly mortgage payment, you pay $24,000 annually. If you make a $1,000 biweekly mortgage payment, however, you will pay $26,000 total, meaning you have made one extra payment. This strategy may be easier on your budget than increasing each month’s payment by 1/12 or simply making one extra payment annually.
Using a mortgage payoff calculator can help you determine how much you can save based on how much extra money you can afford to put toward your mortgage.
Dig deeper: 7 ways to pay off your mortgage faster
Making an extra payment to your mortgage each year will reduce the length of your repayment by several years — generally between four and six years. It will also lower the amount you pay in interest over time and help you build home equity more quickly.
Either option will have approximately the same effect. For most homeowners, increasing their monthly mortgage payments by 1/12 is easier than making one extra mortgage payment once per year.
Extra payments may not automatically be applied to your loan principal. Some mortgage lenders apply extra payments to future scheduled payments rather than principal. To ensure you are paying the mortgage principal with your extra payment, inform your lender that you want the additional money applied specifically to your principal.
This article was edited by Laura Grace Tarpley