Mortgages are a good thing; you can buy a home and pay it off over time. Without home loans, real estate could only be sold with cash, leaving most of us on the sidelines. Lenders however aren't in business for free. They charge interest each month in return for providing money at the closing table so you can buy your first home. And with a VA loan, you not only got a loan but you did so with no money down. Sometimes though, a windfall appears. A bonus at work, an inheritance or even accumulated savings begins to pile up.
Should you pay down your mortgage? Even if you don't have a large amount of money to pay against your outstanding loan, it can be a good thing to pay off your home loan with just a little extra each month. One note, speak with a financial planner when considering making a large payment toward your existing VA loan. This isn't necessarily an endorsement of paying down a mortgage in big chunks but if you do, your mortgage payments will react differently.
Bi-Weeklies
It's possible that soon after you first closed on your home, you received a notice or two from companies that want to set up a bi-weekly mortgage plan. For a fee, a bi-weekly payment plan collects makes one-half of your standard mortgage payment amount every other week. This bi-weekly approach is in essence one extra payment per year, gradually reducing your mortgage balance at a faster rate. Making a payment every other week means making 13 mortgage payments per year instead of 12.
When you make one extra payment per year on a 30 year fixed rate loan, you can knock off about seven years from your VA loan. But you don't have to use the services of a bi-weekly payment company; you can establish your own bi-weekly program.
Your lender however, won't allow you to pay every other week. Your loan papers say your mortgage payment is due in full on the first of every month. What you can do however is pay extra on your loan anytime you feel like it because VA loans do not have any sort of prepayment penalty.
Divide one month's principal and interest payment by 12, then add that amount each month to your mortgage payment. That makes 13 payments per year, giving you the same result you'd get signing up with a bi-weekly plan.
Making Large Payments
But let's say you are the lucky one and do have a chunk of cash to pay toward your mortgage and you've determined that significantly reducing your principal is a good thing. What happens?
Obviously, your outstanding balance is reduced but depending upon the type of loan you have, your monthly payments may or may not be reduced. How can that be? If your loan balance is lowered, shouldn't your payments go down as well?
That depends if you have a fixed rate loan or an adjustable rate mortgage.
Fixed Changes
A fixed rate mortgage is just that: it never changes. A fixed rate VA loan is amortized over a predetermined period, most often in terms of 15 or 30 years. Each month, the same payment is made with part going toward principal and part in interest to your lender.
Early on, the bulk of the payment goes toward principal and interest. This is because the interest rate is calculated on the remaining balance of the loan and each month as the loan is paid down, the interest rate is applied to a slightly lower amount.
For example, if you have a 30-year mortgage at 7 percent on $400,000, your principal and interest payment is $2,661. In the first month you paid $328 toward your principal and $2,333 to interest. Ten years later, that same $2,661 payment is broken down into $659 toward principal and $2,002 to interest.
Now let's say you pay $300 extra every month toward your principal. What happens? First, your payment stays the same; it's still fixed. But you reduce the life of the loan. Your loan balance drops in year six to about $275,000 instead of about $335,000 without the additional paydown. In this scenario your mortgage is also paid off in just over 22 years, instead of 30 years.
The ARM Change
With an adjustable rate mortgage, or an ARM, your loan payment actually drops when you make a onetime payment. ARM payments are "recast" using the outstanding balance of the loan, the remaining term and the current interest rate.
With ARMs, the payment drops but the original loan term remains.
The Advantage
If you determine that paying down your mortgage is to your advantage, it's important to understand how your existing mortgage will react. With a fixed rate loan, the loan is shortened. With an ARM, the payment is reduced.
And if you don't want to make a sizable principal reduction, you can accomplish similar interest savings by applying your plan in tinier steps, paying just a little extra each and every month can save you thousands in long term interest.
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