How Mortgage Overpayment Is Applied?
Many homeowners include extra money when remitting monthly mortgage payments, and this practice of overpayment can lead to considerable differences over the life of the loan. Although homeowners can save money by overpaying, some could see more benefit by using the overpayment money elsewhere and some may find themselves paying hefty prepayment penalties.
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Function
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In many cases, according to financial experts at Money UK, banks apply mortgage overpayments to the outstanding principal balance. In a typical arrangement, according to the financial website Lending Tree, a mortgage payment covers expenses for principal, interest, taxes and insurance, a combination known in the mortgage industry as PITI. After the bank disburses funds to satisfy payment requirements for PITI, the institution can apply remaining funds toward the principal balance.
Caution
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Although Money UK notes that banks typically apply overpayments toward reducing the principal balance, not all mortgages work the same way. Some lending institutions may apply overpayments toward the next month's payment or toward interest on the loan. In addition, Money UK notes that some lenders do not allow overpayment at all; these lenders may return a payment that exceeds the regular installment amount. Other lenders may impose hefty penalties when homeowners begin prepaying a mortgage, and these additional costs can negate the benefit of overpaying.
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Benefits
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If a lender allows prepayment of a mortgage principal balance, homeowners can save a considerable amount of money by overpaying throughout the mortgage lifetime. According to the financial website Love Money, banks charge interest on the outstanding principal of a mortgage. As the bank applies overpayments toward the principal balance and the outstanding amount falls, the interest charges apply to a lower amount. This change results in lower interest costs over the life of the loan, and savings can range into the tens of thousands of dollars. In addition, homeowners who overpay will likely pay off a loan more quickly than those who do not. Those who overpay mortgage payments also reduce the difference between the home value and the outstanding debt, and the resulting equity can serve as a safety net in the event of unanticipated expenses.
Considerations
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Though overpaying a mortgage carries a number of benefits, some homeowners may find more benefits in using the overpayment funds for other purposes. Money UK observes that homeowners who carry credit cards may pay higher interest rates on the credit card balances than on the mortgage, and these homeowners could see more savings by paying off the card accounts than by overpaying the mortgage. Money UK also cautions that homeowners should not use all available funds to overpay a mortgage, as setting aside money in a savings accounts could help reduce the need for credit cards or loans should an unexpected expense arise.
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References
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