by Gary Foreman

Buying a home can be an important part of wealth building. Here’s what you should know about properly managing your mortgage to help ensure your mortgage actually improves your financial well-being.

Gary,
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. Managing your mortgage payments wisely 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.

The Basics of Managing Your Mortgage

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”).

Escrow Account

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 you periodically. But, if there isn’t enough money to pay for insurance or taxes, you’ll be asked to make up the difference and increase the amount that you put into the escrow account each month.

Private Mortgage Insurance

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.

How Should Extra Money Be Appiled to Your Mortage in Order to Build Wealth?

Now let’s look at whether any extra money should go to principal or escrow. And the answer is that depends on what you want to accomplish with it.

When to apply extra money to escrow

Perhaps you’re afraid that the escrow account won’t have enough money to pay for increased property taxes. Then you might want to put some extra in now so that you don’t have to worry about coming up with the money later.

When to apply extra money to principal

But, if you’re not concerned with the escrow account, you should earmark the extra amount to principal. The reason is simple. Prepaying your mortgage is one of the best ways to accumulate wealth.

An example

Consider an example. We’ll use a high rate of interest to help illustrate the point. 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.

Some Should-Dos when Managing Your Mortage

There are some other things that you should do to manage your mortgage.

Elimate PMI ASAP

The first is to eliminate PMI as soon as you can. If your equity is greater than 22%, federal law says that you cannot be forced to buy PMI unless you’ve been late with your payments.

You will need to monitor this yourself. There’s two ways that your 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 you get over 22% equity in your home, you’ll want to contact the mortgage company and cancel PMI. This is also a good opportunity for you. You can take the money that had been going to PMI and redirect it to prepaying principal. Your payments will remain the same, but your mortgage will begin to shrink.

Watch your escrow account

You also need to manage your 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.

Regulary compare homeowners’ insurance rates

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.

Know when it might be wise to refinance

Finally, be aware of the different types of mortgages available and refinance if that works to your advantage.

• How Mortgage Prepayments Work
• Why You Shouldn’t Pay Off Your Mortgage Early
• 3 Strategic Uses for a Reverse Mortgage Line of Credit
• What Empty Nesters Need to Know About Homeowners Insurance
• Should I Pay Off My Mortgage Before I Retire?
• Prepay Mortgage or Increase Retirement Savings?

Reviewed January 2022

About the Author

Gary Foreman is the former owner and editor of the After50Finances.com website and newsletter. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.