Many homeowners look forward to the day when their mortgage will be paid off and the biggest debt of their lives will be behind them. What they may not realize is that the day could come a lot sooner if they just pay a little extra each month.
In this article, we’ll show how to make that happen.
- Making extra payments toward your mortgage principal each month can save you a substantial amount of interest over the long term.
- It can also allow you to pay off your mortgage in full much faster.
- But before you add to your mortgage payments, consider paying down any high-interest credit card debt that you may have.
How an Amortization Schedule Works
How mortgages work—and why even modest added payments can go a long way—is best understood by looking at a typical amortization schedule. Basically, that’s a table listing each scheduled mortgage payment in chronological order, beginning with the first payment and ending with the last one.
In an amortization schedule, every monthly payment is split into two parts: an interest payment and a principal payment. Early in the amortization schedule, a large percentage of the total payment goes toward interest, with a small percentage going toward principal. As you continue to make mortgage payments over the months and years to come, the amount allotted to interest gradually decreases and the amount allotted to principal increases.
Using a mortgage calculator is a good resource to understand these amounts.
How to Calculate Amortization
Here is an example of how an amortization schedule is calculated.
The Monthly Payment
The total monthly, or “periodic,” payment (shown in Column 5 of the table below) is determined using this formula:
A=1−(1+i)−nPiwhere:A=periodic payment amountP=mortgage’s remaining principal balancei=periodic interest raten=number of remaining scheduled payments
As you can see from the table, the monthly payment stays the same for the life of the loan. (For the sake of space, only the first five months and the last five months are shown.)
The Monthly Interest Payment
The interest portion of the monthly payment (Column 6) declines over time as principal is paid down. It is calculated by multiplying the interest rate (Column 3 ÷ 12) by the remaining principal balance (Column 4). Note that the interest rate shown in Column 3 is an annual interest rate and must be divided by 12 (months) to arrive at the periodic interest rate.
The Monthly Principal Payment
The principal portion of the monthly payment (Column 7) is simply the total monthly payment minus that month’s interest payment.
How Extra Payments Can Pay Off
The second table here is also an amortization schedule for a 30-year, 8% fixed-rate mortgage. But this time, the borrower is making an extra $300 payment toward principal each month. (While 8% is a high interest rate by today’s standards, it will work here for illustration purposes.)
This amortization schedule shows that paying an additional $300 each month will shorten the life of the mortgage from 30 years to about 21 years and 10 months (262 months vs. 360). It will also reduce the total amount of interest paid over the life of the mortgage by $209,948.
As you can see, the principal balance of the mortgage decreases by more than the extra $300 that you throw at it each month. For example, if you pay an extra $300 each month for 24 months at the start of a 30-year mortgage, the extra amount by which the principal balance is reduced is greater than $7,200 (or $300 × 24). The savings by the end of those 24 months in this example is actually $7,430.42. So you would have saved more than $200 additionally in that period alone—and the benefits will only increase as they compound through the life of the mortgage.
That’s because an ever-larger percentage of your regular scheduled mortgage payment will go toward principal rather than interest, as you continue to make those $300 extra payments.
A further benefit of lowering your mortgage debt is that it reduces your financial risk overall. If you lose your job or face some other financial reversal, you will have that much less debt to keep you up at night. Plus the greater equity that you will have built up in your home will make it easier to get a home equity loan or reverse mortgage if you ever wish to.
The Downside of Accelerated Payments
The financial benefit of making accelerated mortgage payments is well illustrated by the example above. But does that mean it is always your best choice? That depends on what other uses you might have for the money. This concept is often referred to as opportunity cost.
For example, if you’re carrying a substantial amount of credit card debt, paying an extra $300 a month toward that balance could be a better idea. The median interest rate on credit cards in the Investopedia database recently stood at 19.49%, while most mortgages charge just a small fraction of that.
Suppose, for example, that you owe $10,000 on a credit card with an interest rate of 19% and have been making a minimum monthly payment of $300. If you were to bump up that payment to $600, you would save about $2,626 in total interest ($1,703 vs. $4,329) and have the balance paid off 28 months sooner (20 months vs. 48).
After that, assuming you don’t run up another big credit card bill in the meantime, you could start applying the extra $300 to your monthly mortgage payments.
Similarly, if you’re an investing whiz, your $300 might earn more in the stock market than you would save on your mortgage. However, few of us are investing whizzes, and paying down your mortgage faster is the closest that most of us will ever come to a sure thing.