Today we’ll look at the strategy behind adding a little extra to your mortgage payment each month. This process basically does two things; it saves you money by knocking your principal down quicker which effectively reduces the amount of interest you have to pay and it reduces your loan’s payoff period. I think that a good first step in this discussion would be to understand how exactly your monthly mortgage payments are broken down. To do this, we’ll use an amortization schedule. This table is simply a loan repayment schedule of sorts; it breaks down each payment so you can see how much of the payment is going toward the principal and how much is interest. You can also see the effects of extra payments and rate changes on the overall amount of interest you’ll pay over the life of the loan.
For our example, we’re going to use a 30yr fixed rate mortgage at 5.5% and a loan amount of $200k – you’ll see these figures in the top row highlighted in yellow. To the right, in the same row, you’ll see the monthly payment for this mortgage in BLUE, this is your minimum required payment. Beside that, in GREEN, is the total amount of money that comes out of your pocket to pay off that $200k mortgage (principal plus total interest paid) over the 30 year period. And lastly, in ORANGE, you’ll see the total amount of interest you’ll pay over the course of the loan. If you’re turned around on how exactly interest and payments are calculated, you can visit our mortgage calculators page to get yourself oriented.
If you look at the second line, in PURPLE, you’ll see how the first payment is broken down. Of the $1135.58 – $218.91 (19%) goes toward your principal, and the rest ($916.67) covers the interest. Now take a look at the loan balance in line one – that $218.91 barely made a scratch in the principal. Next, let’s move down to the fourth mortgage payment on line two (4). The required payment is the same but the principal and interest portions have shifted slightly. As the months go by, you’ll see that more of your monthly payment is going toward the principal as the overall loan balance decreases. So that’s the basics of an amortization schedule. If you want me to email you a blank excel spreadsheet that you can fool around with on your own, just email me.
Now let’s look at how making extra payments will affect these numbers. Let’s just say, that after running over your monthly budget, things are looking good and you have $200 extra that you’d like to put toward your mortgage every month. So you make the commitment and start adding that 200 onto your payment. If you stick with it until the end, below is what your updated amortization table will look like. Check out the principal column – you’re nearly doubling the contribution with that extra $200 during the months shown. The percentage of your payment going to the principal goes from 19% to 37%. MOST importantly, compare the total payments (green) and the total interest paid (orange) – by making these extra payments – you’re skipping out on $97,826 worth of interest – not bad at all.
Lastly, let’s look at the affect of these payments on the payoff period. Typically the 30 yr fixed rate loan would take 360 payments to pay off – 12 per year for 30 years. But, because we’ve made our extra payments, we’ve almost cut the loan term in half – from 30 years to 17 years and two months.
The long and short of it is this: we’ve put quite a bit of money toward the mortgage than we had to, but we saved a ton and shortened the term of the loan. I really suggest this strategy to those who plan on staying in their home for quite a while and who really want to get this monthly payment off their books. It’s definitely not for everyone and there are some other (better) ways your money could be working for you, but regardless, lots of folks want to pursue this avenue and I thought I’d give a clear explanation of how what affects it has on your loan.
Questions? Comments? – just shoot me an email at firstname.lastname@example.org
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