Five strategies to tackle high mortgage rates

This often leads buyers to take on larger, more expensive loans than anticipated to help achieve their home purchasing goals. While it may be tempting to pay such loans off as fast as possible, it may not be the best approach when reviewing one’s financial situation as a whole.

When mortgage rates are high, every dollar of principal you eliminate can produce a meaningful, guaranteed reduction in future interest costs, making prepayment an attractive option. However, every dollar sent to the mortgage becomes home equity, not money you can easily access in the case of an emergency. The best approach is much more nuanced, emphasizing a focus on reducing interest expenses without weakening your liquidity or ignoring more valuable priorities. The following represents just a few strategies one might consider when facing a higher mortgage interest rate.

Paying more than the minimum

Adding even a modest amount to each payment reduces an outstanding principal sooner, meaning less interest accrued in the future. The earlier you start, the more powerful the effect can be due to the larger initial balance.

Looking at an amortization calculation to illustrate the point, a $400,000, 30-year mortgage at 7% has a principal and interest payment of about $2,661 per month. Paying an additional $200 a month from the start would pay the loan off roughly 70 months earlier and could save over $126,000 in total interest expense.

If paying more than the minimum is an option for you, there are several approaches to consider. You can add a fixed principal amount to each payment, contribute one twelfth of an extra payment each month, make one additional principal payment annually or use a true bi-weekly payment schedule. A true biweekly plan produces 26 half payments equaling 13 full payments a year. Before using a biweekly plan, confirm how partial payments are credited and whether a fee applies.

Whatever method you choose, be sure to check with your mortgage provider to understand if prepayment penalties could be applied. If not, instruct them to apply every extra payment amount to principal and verify it on your next statement.

Lump sum payment with recast

A mortgage recast, sometimes called re-amortization, recalculates the required principal and interest payment after a substantial lump sum payment has been made. The provider then spreads the remaining balance over the remaining term at your existing interest rate. You keep the same loan, typically avoiding the larger closing costs associated with refinancing – but reduce your monthly principal and interest payment.

A recast is most useful when you receive a bonus, inheritance, or other substantial proceeds and seek a lower monthly payment or are looking to deploy monthly capital to more advantageous opportunities. To be clear, this approach does not lower your interest rate and generally does not shorten your payment term. If your goal is maximum interest savings and not a reduction in your monthly expense, make the lump sum payment but continue paying your old monthly amount even after the required payment is reduced.

Recasting is not automatic nor universally available. Ask your servicer about eligibility, the minimum principal reduction, fees, whether your loan type qualifies and any other requirements.

Refinance when the math works

Lower market rates than your own can make refinancing attractive, but a lower payment alone does not mean you instantly save money. Closing costs, a reset loan term and mortgage insurance can erase the benefit from refinancing if you merely consider the new lower rate.

A useful first screen is calculating the breakeven period by dividing the upfront costs by the potential monthly savings. For example, if a refinance saves you $250 per month but costs $6,000 in fees, the simple breakeven point is 24 months. Meaning, if you expect to sell, move or refinance again before 24 months have passed, the refinance may not pay for itself. Also, one must consider that in reducing your payment, the tradeoff is extending your payment schedule due to the new loan’s term.

Eliminate PMI

If your mortgage carries private mortgage insurance (PMI), directing additional money to principal can produce two layers of savings, lower future interest costs and earlier removal of the monthly insurance premium. This can make principal payments especially valuable when your balance is approaching the cancellation threshold.

Federal rules generally allow eligible borrowers to request PMI cancellation when the outstanding balance reaches 80% of the home’s original value, subject to varying conditions. PMI generally terminates automatically when the scheduled balance reaches 78% of the original value if the loan is paid and current. Different rules apply across mortgage providers, so be sure to confirm the requirements with your servicer before relying on this strategy.

Prepayments in the “Big Picture”

A 7% mortgage prepayment is not unlike earning a guaranteed 7% return before considering taxes, but it’s important to remember that home equity is illiquid on your balance sheet.

Before accelerating your mortgage payments it’s important to maintain an adequate emergency fund, maximize any employer retirement matching and eliminate debt with a high after-tax cost, such as outstanding credit card balances. One should also compare additional mortgage principal payments against retirement savings priorities, near-term spending needs and other primary goals you may have.

Conclusion

Aggressively paying down a high-rate mortgage can be tempting, especially for those that are debt averse, but it should not leave you house rich and cash poor. If you’re interested in how you can potentially reduce the impact of a higher interest mortgage, speak to your Mesirow wealth advisor about the options you may have as part of your overall financial plan.

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