Freedom from debt is a common and powerful financial goal. Owning your home free and clear with no other debts gives you a strong financial base for whatever plans you may have in life.
In most situations, you will save money if you make extra payments on an existing mortgage. Doing so will directly reduce the balance on your mortgage, which means that for the rest of the life of your mortgage, the amount of interest you’re charged each month is lower. That means each subsequent mortgage payment will have more going to the principal amount than it would have before, and the end result is that your mortgage is paid off months or even years earlier than it would have been otherwise, even with just a single extra mortgage payment early in the mortgage.
One potential hazard in that path to financial freedom is the fact that, in some cases, a lender won’t allow you to easily make extra payments on your mortgage. They’ll use various mechanisms to keep you from actually reducing your mortgage balance, such as penalties, suspense accounts and partial payment accounts, that result in little progress toward paying off your mortgage even if you’re trying to pay it down quickly.
What are these things, and how can a homeowner seeking financial freedom get around them?
What is a prepayment penalty?
A prepayment penalty is an extra fee charged by some home lenders in the event that you pay off too much of your mortgage early. The exact terms of the prepayment penalty are spelled out within a clause in your mortgage agreement.
Typically, it only applies if you pay off the entire mortgage balance at once, but some clauses apply if you pay off a specified portion of your mortgage at once.
[ Next: Should You Pay Your Mortgage Off Early? ]
Why do lenders charge a prepayment penalty?
Lenders make money when you pay off your mortgage in steady monthly payments, as each payment includes interest that goes in their pockets. If you pay off the mortgage early, the lender loses that income. A prepayment penalty is thus a form of insurance for the lender against you paying off your mortgage too quickly.
This doesn’t just affect people who want to pay off their mortgage quickly, but it also affects those who choose to refinance through a different company. In that situation, the new company will pay off your previous mortgage in full and get hit with that prepayment penalty, which would then be added to the balance of your refinanced mortgage, making it less of a good deal.
What is a suspense account?
A suspense account is an account set up by a lender to hold a borrower’s funds in a suspended state until the lender decides how to allocate them. In the case of a mortgage, if your mortgage specifies the use of a suspense account, any extra payments you make would be deposited into that account.
Thanks to the Dodd-Frank Act of 2010, there are some limitations to the use of suspense accounts. They can only contain an amount less than a full mortgage payment. So, if you make an extra payment on your mortgage that’s less than a full monthly payment, it would go into that suspense account until you made enough extra payments to add up to a full monthly payment, which would then be applied to your mortgage.
To find out if any extra payments on your mortgage would be applied to a suspense account, you can check your mortgage documentation.
What is a partial payment account?
A partial payment account refers to a specific use of an expense account. In this case, it is used in the situation where you make a partial payment on your mortgage rather than a full one. Let’s say, for example, that you decide to pay your mortgage bill by making a half payment every two weeks. Your first partial payment would go into the suspense account, then when your second partial payment arrives — making a whole payment — it would then be applied to the mortgage. Again, check with your mortgage documentation to find out if your lender utilizes a partial payment account.
What’s the problem? The problem is that the lender is holding your money in limbo while it waits for the rest of your mortgage payment to arrive. During that time, you don’t have it available to you in an emergency and you’re not earning any return on it, but it’s not been applied to your mortgage either.
The best way to avoid this is to simply only make full extra mortgage payments. Pay exactly what you owe each month, then when you can afford to make a full extra mortgage payment, do so.
How to avoid a prepayment penalty on your mortgage
With some mortgages, a prepayment penalty can kick in if you pay too much of your mortgage in advance. This can be a big issue if you want to pay your mortgage off early or refinance. Here are some things you can do to avoid a mortgage prepayment penalty.
Talk to your lender
The first place to start is to talk to your lender, ideally before you ever sign on the dotted line for your mortgage. Ask that your mortgage not include any sort of prepayment penalty clause. If the lender is not willing to do that, shop around for a different mortgage.
If you already have a mortgage, it can’t hurt to ask, especially if you are interested in refinancing with the same lender. Mention the possibility of refinancing into a new mortgage without a prepayment penalty.
Refinance your mortgage
Even with a prepayment penalty, refinancing with a different lender may still be the best option if it lowers your overall interest rate. However, you should make sure that your new mortgage does not include a prepayment penalty. Spending the time to shop around for a great refinancing rate can save you a lot of cash, especially if you have equity built up and your credit has improved since your initial mortgage.
Only make full extra payments
If you’re not looking to pay off the full balance all at once, you can still improve your financial situation a little by only making full extra payments on your mortgage. This avoids having any partial payments placed in a suspense account, even for a while. If you don’t have enough to make a full extra payment, keep saving.
Invest your extra payments instead
If your mortgage is locked in at a very low interest rate but has a prepayment penalty, you may want to consider just investing your extra payments instead. This might be a good opportunity to bump up your workplace retirement plan contributions or start saving for a child’s college education with a 529 college savings plan.