Secrets to paying down your mortgage wisely

Terence Loose
Secrets to paying down your mortgage wisely
(Photo credit: Thinkstock)

Are you looking for ways to save money? Of course you are - we all are. But before you cut out life's little luxuries like heat, food, and - perish the thought - HDTV, you might evaluate the savings potential with your mortgage. It could offer some surprising ways to save money, without having to make too much of a sacrifice.

So stay warm, eat, keep that big screen, and check out these ways you might be able to save on your mortgage.

Saver #1: Make Extra Payments

"Wait a minute," you might be saying. "Isn't making extra payments the opposite of saving money?"

When it comes to mortgages, no. In fact, in the long run, this strategy could save you a lot of money in interest. And as a bonus, it could have you owning your home much sooner than you planned.

The most common way to go about this strategy is to set up bi-weekly payments of your current mortgage payment, says Jim Duffy, a mortgage banker with Cole Taylor Mortgage. Simple math shows that because you'll make 26 payments a year, you will actually make the equivalent of 13 monthly payments, opposed to 12. That's one extra mortgage payment annually, allowing you to pay off your mortgage earlier.

"By paying off your mortgage sooner, you save a lot of money in interest," says Duffy. But he cautions that this approach might require contacting your lender to make sure the extra payments go toward your principal.

To see how much this could potentially save you, let's run through an example. We'll use a 30-year fixed-rate loan of $300,000 with an interest rate of 5 percent. Our mortgage start date is January 2013.

  Monthly Payment Plan Bi-Weekly Payment Plan
Loan Amount: $300,000 $300,000
Payment Amount: $1,610.46 (monthly) $805.23 (bi-weekly)
Total Interest Paid: $279,767.35 $228,232.48
Payoff Date: December 2042 March 2038

The Bottom Line: Make that one extra payment per year and you'll not only own your home four years and nine months earlier, but you'll also save $51,534.87 in interest.

Saver #2: Refinance to a Shorter-Term Mortgage

Making extra payments isn't the only way to save money on your mortgage. Another money-saving move could be to refinance from a 30-year mortgage to a 15-year mortgage.

"If you change your terms substantially and still save in interest, refinancing could make sense. So going from a 30-year mortgage to a 15-year mortgage and saving 0.75 of a percentage point [in the rate] could make sense because of the shorter term and all the money that it saves," Duffy says.

He says that because you're paying off the loan in half the time, you're only paying interest for 15 years versus paying it for 30 years. However, because you are paying off your loan in such a shorter period, your monthly payments will be higher. That's true even with the lower interest rate that 15-year mortgages typically carry.

[Ready to refinance your mortgage? Click to compare rates from multiple lenders now.]

Shall we set up another example to see how much money this scenario could save? Okay. We'll use our usual $300,000 mortgage in 30 and 15-year fixed-rate scenarios. For the rates, we'll use the average market rates quoted for January 17, 2012, according to Freddie Mac.

  30-Year Mortgage 15-Year Mortgage
Loan Amount: $300,000 $300,000
Interest Rate: 3.38 percent 2.66 percent
Start Date: January 2013 January 2013
Monthly Payment: $1,327.12 $2,023.04
Interest Over Life of Loan: $177,762.87 $64,147.51
Payoff Date: December 2042 December 2027

The Result: What a difference 15 years makes, huh? Specifically, $113,615.36 in interest saved.*

Saver #3: Shop Lenders

If you were under the impression that all lenders would offer you the same interest rate and the same terms for your mortgage or refinance, think again. Whether you're shopping for cars, homes, or even a good pineapple, you should take advantage of the fact that you have a choice - and it could save you money.

But before you get all excited about getting a wildly lower interest rate from one lender compared to another, cool your jets. Duffy says that because interest rates are at historic lows, there isn't that much wiggle room for lenders to offer drastically different rates. So a quarter to a half a percent is about the best to expect.

"Still, a seemingly small difference in the interest rate can make a pretty big difference in interest paid over the life of a loan," he says.

Something to consider though, according to the Federal Reserve Board, or FRB, which oversees the U.S. monetary policy, is that buyers and sellers are typically free to negotiate which party pays certain mortgage or refinancing fees. So even if you don't have a lot of power in terms of negotiating interest rates from different lenders, you could have the power to negotiate other costs.

Saver #4: Refinance to a Lower Rate Than You Have

Okay, so this isn't so surprising because everyone knows that if you lower your interest rate, you'll likely lower your monthly payments and the amount you pay in interest over the life of your mortgage.

And to put into perspective how low the current mortgage rate really is - the January 17, 2013 average from Freddie Mac was 3.38 percent - consider that mortgage interest rates were 6.10 percent just five years ago in December of 2007 - and 17.16 percent in March of 1982 (ouch!), according to data from the FRB.

And even a drop in the mortgage rate of just one percent can make a big difference. "The general rule of thumb is that if you can lower your interest rate by a percent or more, it probably makes sense to refinance," says Duffy.

So again, let's go to an example. This time we'll use scenarios for two borrowers who have $300,000 30-year, fixed-rate mortgages. Borrower A has an interest rate of 6 percent. Borrower B has a rate of 5 percent. Then we'll show their new payments if they refinanced to a 3.5 percent interest rate.*

  Borrower A Borrower B Refinanced
Loan Amount: $300,000 $300,000 $300,000
Interest Rate: 6 percent 5 percent 3.5 percent
Monthly Payment: $1,798.65 $1,610.46 $1,347.13
Interest Over Life of Loan: $347,514.57 $279,767.35 $184,968.26

The Result: By refinancing, Borrower A saved over $451 per month and an impressive $162,546 in interest over the life of the mortgage. Borrower B didn't do too badly either, with a monthly payment savings of over $236 and a life-of-the-loan interest savings of $94,799. All thanks to a reduction in rate of a few percentage points.

Saver #5: Keep Tabs on Your Home Equity

You might be wondering what your home equity has to do with saving money. But if you're paying Private Mortgage Insurance, or PMI, knowing how much equity you have in your home can save you some cash.

First, let's examine what PMI is. PMI is an insurance that protects the lender against you defaulting on your mortgage. The FRB says that lenders usually make you pay it when your equity (the difference between the purchase price of your home and the mortgage amount) is below 20 percent, according to a mortgage refinancing guide published by the FRB. And PMI could cost anywhere from .5 to 1.5 percent of your loan, according to the FRB.

Now that you have that background, here's why keeping tabs on your home equity is important to saving you money: By law, your lender is required to stop charging you PMI after you accrue 22 percent equity in your home.

But, if you simply write a letter to your lender once you've built up 20 percent equity in your home, you can stop paying PMI then and there - instead of waiting until your equity hits 22 percent.

*The average market interest rate for a 30-year fixed-rate mortgage was 3.38 percent as of January 17, 2013, according to Freddie Mac, an institution established by Congress in 1970 to provide liquidity, stability and affordability to the nation's residential mortgage markets. Also, examples of refinancing scenarios do not take into account the interest - or principal - already paid over years of your current loan.