|Gary Foreman is a former Certified Financial Planner (CFP) who currently writes
about family finances and edits
The Dollar Stretcher website
http://www.stretcher.com. You'll find hundreds of FREE
articles to stretch your day and your budget!
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 asks a very good question. How
you manage your mortgage payments can make a big difference in your
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
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
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
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
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.