by Gary Foreman
When I send in my mortgage payment and I send in more than the minimum amount, the return payment stub asks whether I would like the additional payment to go towards escrow or principal. Which direction would be the best? Jim
Jim asks a very good question. How you manage your mortgage payments can make a big difference in your financial well-being.
Let’s begin with a little background about mortgages. Many of you will already be familiar with this, so just consider it a review.
When you take out a mortgage you’ve borrowed money. And, you’ve agreed to pay interest to the mortgage company for the amount of money that you owe. On all but a few mortgages, you’ll make monthly payments. Part of that monthly payment will go towards the interest that’s owed for that month. Another part of the payment goes to repay the amount borrowed (called “principal”).
Your mortgage payment may also include an “escrow” account. That’s where the mortgage company collects an extra amount each month from you. Then when your homeowners’ insurance or property taxes are due those bills are paid from money in the escrow account. If there is extra money in the account it may be returned to Jim periodically. But, if there isn’t enough money to pay for insurance or taxes he’ll be asked to make up the difference and increase the amount that he puts into the escrow account each month.
Another part of your mortgage check could go to “private mortgage insurance” or PMI. If your down-payment was less than 20% you were probably told that you’d need to buy PMI. That’s an insurance policy that pays the mortgage company if you default on the loan.
Now let’s look at whether any extra money should go to principal or escrow. And the answer is that depends on what he wants to accomplish with it.
Perhaps he’s afraid that the escrow account won’t have enough money to pay for increased property taxes. Then he might want to put some extra in now so that he doesn’t have to worry about coming up with the money later.
But, if he’s not concerned with the escrow account, he should earmark the extra amount to principal. The reason is simple. Prepaying your mortgage is one of the best ways to accumulate wealth.
Consider an example. Suppose that Jim had a 30-year 7% mortgage with a monthly payment for principal and interest of $665. If he were able to put $1,000 toward principal next month it would shorten his mortgage by one year. Or, suppose that he’ll be selling the house in 7 years. In that case, he’ll have $1,700 more when he walks away from the closing table.
Prepaying your mortgage is often the best investment you can make. You’re guaranteed a rate of return equal to the mortgage interest rate. And, if you ever need to get the money back, it’s fairly easy to take out a home equity loan or refinance your home.
There are some other things that Jim should do to manage his mortgage. The first is to eliminate PMI as soon as he can. If his equity is greater than 22% federal law says that he cannot be forced to buy PMI unless he’s been late with his payments.
Jim will need to monitor this himself. There’s two ways that his equity can increase. Either by gradually paying off the mortgage principal amount. Or, by the value of the house going up due to rising real estate prices.
When he gets over 22% equity, Jim will want to contact the mortgage company and cancel PMI. This is also a good opportunity for Jim. He can take the money that had been going to PMI and redirect it to prepaying principal. His payments will remain the same, but his mortgage will begin to shrink.
Jim also needs to manage his escrow account. Many communities give a discount if you pay your property taxes early. Or, penalize you if you don’t pay on time. Make sure that the mortgage company is taking advantage of any discounts available to you. Remember that your mortgage is one of thousands that they manage and clerical mistakes commonly occur.
It’s also a good idea to regularly shop your homeowners’ insurance. Just because it is being paid from the escrow account doesn’t mean that you aren’t allowed to find a lower rate and change insurers.
Finally, be aware of the different types of mortgages available and refinance if that works to your advantage.
The time when Jim could take a mortgage, make monthly payments and forget about it are over. Managing his mortgage is an important part of building wealth.
Gary Foreman is a former financial planner who currently edits The Dollar Stretcher website.