Prepaying your mortgage: How reducing your loan principal can lead to big savings

When you prepay your mortgage, it means that you make extra payments on your principal loan balance. Paying additional principal on your mortgage can save you thousands of dollars in interest and help you build equity faster.

There are several ways to prepay a mortgage:

• Make an extra mortgage payment every year

• Add extra dollars to every payment

• Apply a lump sum after an inheritance or other windfall

• Some combination of the above

The benefit of paying additional principal on a mortgage isn't just in reducing the monthly interest expense a tiny bit at a time. It comes from paying down your outstanding loan balance with additional mortgage principal payments, which slashes the total interest you will owe over the life of the loan.

Another consideration is the opportunity cost of not having that extra money invested elsewhere. Over the past four decades, the stock market has returned an average 10% a year. For the broad bond markets, the average annual gain has been close to 8%.

When asking yourself, "Can I prepay my mortgage?" look at your entire financial picture. Here are some important questions to consider, including:

Is your monthly budget tight after meeting necessary expenses? Is your income variable and/or unpredictable? How long do you plan to stay in your home? Are you saving enough for retirement? Do you have an adequate emergency savings fund of three to six months of household living expenses? Do you have a lot of high-interest credit cards or loans?

Assessing your financial goals, income and budget can help you decide whether it makes more sense to address other pressing financial concerns before paying ahead on your mortgage.

Prepaying your mortgage is a great goal to work toward but before you do, make sure you have met these financial milestones first:

• Pay off your higher-rate debt. It doesn't make sense to pay off a 4% mortgage if you have credit cards accruing at 16% or more.

• Plan for emergencies. A savings account with at least three to six months' worth of expenses can help you weather most setbacks.

• Protect yourself. You should be adequately insured, which for most people means having property, health and disability policies. If you have financial dependents, you will probably want life insurance, as well.

Once those bases are covered, prepaying a mortgage comes down to discipline and comfort level. Do you want to be completely debt-free? Or would you prefer your money working harder for you in other ways?

Ideally, you want to pay off your mortgage before retirement so you don't have those monthly payments to worry about if your income becomes more limited.

Make sure you earmark any additional principal payments to go specifically toward your mortgage principal. Lenders typically have this option online or have a process for earmarking checks for principal payments only. Ask your lender for instructions.

If you don't specify that the extra payments should go toward the mortgage principal, the extra money will go toward your next monthly mortgage payment, which won't help you achieve your goal of prepaying your mortgage.