So you've come into some extra money. Congratulations! Now you might be wondering about the best use for it. If you're already doing OK on your more immediate financial goals like saving for emergencies, a lump-sum mortgage payment can be a great idea.
Making a lump-sum payment always saves you money on interest. And depending on how you handle it, the payment will either shorten the time it takes to pay off your mortgage or reduce your monthly payment amount.
- Make sure that your mortgage doesn't charge prepayment penalties before making a lump-sum payment.
- Extra mortgage payments are generally applied to your principal so that they shorten the amount of time it takes to pay off your mortgage.
- You may be able to "recast" your mortgage. This means you will still pay it off by the original date but with new, smaller monthly payments.
What Happens When You Make a Lump-Sum Payment
When you make a lump-sum payment on your mortgage, your lender usually applies it to your principal. In other words, your mortgage balance will go down, but your payment amount and due dates won't change.
Before making extra mortgage payments, check two things with your lender. Make sure there are no prepayment penalties, and confirm that your extra payments will be applied to your principal balance, not toward interest.
You could send in an extra mortgage payment every month, but you'll still be required to make a mortgage payment the following month. The only thing that changes is that you'll pay off your mortgage sooner than you'd originally planned, and you'll save money on interest, to boot.
For example, let's say you're five years into a 30-year mortgage at a 3.5% annual percentage rate (APR), with a $500,000 balance remaining. If you used a $10,000 lump sum to pay down your mortgage, you'd shave off 10 months—and $13,500 in interest—from your original payment plan.
However, your normal monthly payment would still be due the next month. You can't pay ahead on your mortgage to take breaks on your payments later if you run into a tough financial patch. If you're worried about being able to make your payments in the future, though, another option might help you: recasting your mortgage.
Recasting Your Mortgage
If you're ahead on your mortgage and want to lower your monthly payment, one underrated option is to simply recast your mortgage. This allows you to pay it off within the original time frame but with new, recalculated payments based on your current balance.
This essentially lets you stretch out your lower-than-expected balance to fit the originally planned term length, thereby making each payment lower.
Recasting your mortgage is only an option for conventional loans. If you have a loan through the VA, FHA, or USDA, you aren't eligible to recast your mortgage.
Recasting has a couple of advantages over refinancing your mortgage.
First, if you already have a low interest rate, recasting your mortgage allows you to keep that rate. This process is also much cheaper than refinancing a mortgage, typically only requiring a (relatively) small administrative fee of $150 to $500, depending on your lender. You still have the freedom to make extra payments and pay off your mortgage sooner if you like, but you're also responsible for less money each month.
If you're interested in recasting your mortgage, contact your lender to find out how. Some lenders have certain requirements, such as paying off $5,000 or $10,000 towards the balance or not being overdue on your mortgage payments.
When a Lump-Sum Payment Makes Sense
Paying down debt is rarely a bad idea. But like many personal finance decisions, it's a matter of choosing between a good option and a better option. Here are some ways to know whether making a lump-sum mortgage payment is the best option for you.
- You don't have any higher-interest debt to pay off, such as credit card debt.
- You're already on track with your other savings goals for emergencies, retirement, college, etc.
- You prefer having more equity that you can tap into later through a home equity loan or line of credit.
- You prefer the safety and security of paying off your mortgage sooner over making riskier, higher-return investment choices.
- You're paying for private mortgage insurance (PMI), and a lump sum will help you gain enough equity in your home to remove this fee.
When Recasting Makes Sense
If making a lump-sum mortgage payment is in the cards for you and you're also trying to decide whether or not to recast your mortgage, here’s how to tell if it might be a good option for you:
- You're ahead on paying off your mortgage or will be soon.
- You're OK with paying an administrative fee of $150 to $500.
- You've contacted your lender to see whether you qualify for a mortgage recast.
- You already have a lower interest rate than what you could get through a refinance.
- You want a smaller monthly payment, but you don't want to refinance your mortgage.
Other Ways To Use Your Extra Cash
Making a lump-sum mortgage payment isn't your only option if you're fortunate enough to have extra money. If you choose to pay down your mortgage, you will have opportunity costs—the value of what your money could have done if you hadn’t used it to pay down your mortgage. Here are some of the other things you could do with that extra cash:
- Upgrade your home
- Pay down other debt
- Invest the money for potentially higher returns
- Save for emergencies, college, vacations, retirement, etc.
Frequently Asked Questions (FAQs)
How much interest will I save on my mortgage with a lump-sum payment?
It depends on how much of a lump-sum mortgage payment you make, your interest rate, and your loan balance. You can easily calculate how much interest you'll save by using a mortgage payoff calculator.
How much does it cost to recast a mortgage?
It typically costs between $150 and $500 to recast your mortgage, depending on your lender's policies. This is significantly less money than refinancing your mortgage would require. The tradeoff is that you're responsible for less money each month.