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Should You Prepay Your Loans?
You know that if you pay off your mortgage or college loan early, you can save a ton in interest costs. That’s good, right? Not for everyone. Before you write that extra check, experts advise, you should consider several things:
What is the interest rate on your loan? If your mortgage is fairly recent and you locked in a rate of 4% or even lower, prepayment might not be for you. That is an extremely low interest rate, and it is unlikely you could borrow money at that low rate again if you needed it. On the other hand, if your rate is high, it might make more sense to prepay.
What are you earning on your investments? Most people say they will use the money they save by prepaying a loan to beef up their investment portfolio. Your first question should be: Are you confident that you will actually do that, rather than take a trip to Fiji? If so, the next step is to see how much you are making on the investments you have. You definitely don’t want to prepay your loan and then invest in something that is returning less than the interest rate on your loan. You also need to remember that, regardless of what the historic return for an investment is, that does not mean that is the return you will get. In fact, you could lose money.
Where do you stand on meeting other financial needs, such as saving for retirement or your children’s education or building a rainy day fund in case you hit a financial rough spot? Unless you are already contributing to your retirement plan at least to the level of the employer match, if there is one, you have savings that could keep you afloat for three to six months and you have a plan for your kids’ education, it probably is premature to consider prepaying a mortgage or student loan.
If you choose to prepay a loan, first check to make sure that there is no penalty for early payment. You also should ask if it matters how you make the early payments. Some people, for example, make one extra full payment a year. Others round up to the nearest $100 in every payment. Others pay what they can when they can.
And be sure to indicate on the check that the additional payment should go to pay down the principal. Otherwise, your lender is likely to apply it to fees or interest, and that won’t help you get out of debt any faster.