If you are a homeowner in the United States, you likely have a mortgage, a loan taken out to pay for your home. The terms of these loans vary but most follow a 30-year payoff plan, with interest being paid in the beginning of the loan. Is there a way to pay your home off faster? Your tax return just may be the answer.
How a mortgage works
When you decide to take out a mortgage to buy a home, you go through a lender to apply for a loan. Once approved, you have a specified amount of time (often 30 years but it may be 15, 20, 25, or any other mutually-agreed upon time) to pay that loan back. How does this work out for the lender? They charge you interest at a rate determine by factors like the current real estate market, your credit history, and your down payment amount.
You make monthly payments on this loan, but only a portion of that goes to the principal balance of your loan. The rest goes towards interest, taxes, and insurance. In the first few years of your loan, a larger percentage goes towards interest, with less going to pay down the actual principal. As time goes on, that balance shifts.
Making extra payments
If you find yourself with some extra money from your tax refund, putting toward your mortgage feels really great. You’re paying off your loan faster! But making extra monthly payments is not as effective as making extra principal payments. When you make a payment, you are able to designate it as a principal-only payment. That means that the entire amount will go toward principal. Reducing the principal results in reducing the interest, which means you pay off your loan sooner.
You are still required to make your normal monthly payment (principal, interest, taxes, and insurance). Making extra principal payments is best done when you have some extra money, such as a tax return. With small steps, you’ll find yourself making that last payment and owning your home free and clear in no time!