Now that we’re past the housing crisis of the last decade and property values have essentially stopped their freefall, it’s worthwhile to take a look at where we stand today compared to just a few short years ago, especially in light of the types of loans available. During the merry-go-round of home buying that created a harmful housing bubble, a flurry of new loans were introduced that are no longer available today.
One of the loan features that was a popular option involved prepaying a mortgage. When someone prepays a mortgage loan, extra payments toward the principal are made, reducing the term of the loan and long term interest paid to the lender. Certain subprime loans and other “alternative” loan types would finance a borrower with less than perfect credit with an understanding that the borrower would not pay down the mortgage ahead of time, either by making extra payments or refinancing out of an existing loan in to another.
How It Works
If a borrower did indeed make extra payments or otherwise pay off the loan, the borrower could be liable for additional penalties due the lender. The lender that originally made the loan took on additional risk but in return required that a specific amount of interest be due to the lender, even if the loan was paid off prematurely. This is a prepayment penalty and could result in thousands of additional dollars to the lender compared to a loan that did not contain a prepayment provision.
Today as yesterday however, prepaying a loan is a good way to build equity while at the same time reduces the interest expense paid to the lender and can be accomplished in a variety of ways and the idea of a prepayment penalty simply doesn’t exist in the current marketplace.
VA loans have never had a prepayment penalty in the history of the program, dating all the way back to 1944 and borrowers could prepay a mortgage at any time for any amount. For example, say someone gets a company bonus every year and instead of spending it, applies it to the mortgage.
Say a borrower takes out a VA loan of $200,000 with a 30 year loan at 4.50 percent. The principal and interest payment is $1,266. In the very first year, $11,167 goes toward interest charges and $4,033 to the loan balance. Over the entire term of the loan, $205,760 goes toward interest charges.
If the borrower makes an extra $5,000 payment per year, the loan is paid off in 18 years instead of 30 and the interest paid amounts to just $107,790, nearly $100,000 less than a 30 year loan taken to term with no prepayments.
Another way to save interest is setting up a bi-weekly payment. For a fee, borrowers can work with a company that will set up a payment pattern where the borrower makes one-half of a regular monthly payment every other week. Doing so will cut five to seven years off a 30 year mortgage.
It’s not uncommon for borrowers who obtain a new mortgage soon find a mailer sent to the home from a company that will set up a bi-weekly plan, again for a fee. The fee is marginal, typically anywhere from $300 to $500 to establish the bi-weekly program. The borrowers make the payments to the bi-weekly servicer who then makes the regular monthly payment to the mortgage company.
Yet this concept doesn’t require paying a fee to a third party to accomplish the same objective and in fact is discouraged. Bi-weekly plans essentially make 26 payments per year, or 13 regular mortgage payments. Instead of 12, the borrower makes 13 payments to save on interest.
The borrower can accomplish the very same objective by mailing in one extra payment each year or in this example, adding one-twelfth of a mortgage payment to each monthly payment. The result is the same—13 payments.
The next question is, “Should you make extra payments?” If you do a search online you’ll find experts that tell you that you should prepay and others who say don’t but instead invest in a retirement fund or some other vehicle.
The real answer however should be answered by you and your financial planner. Yes, there may be some places to put your extra money, but if living mortgage-free sooner rather than later appeals to you, then prepaying your VA mortgage is probably in your best interest.