Home Ownership may be the American dream, but mortgage payments aren’t anyone’s dream. So may have a goal to pay off your mortgage early. You’ll save tons of money on interest, and be mortgage free sooner!
If you’ve thought about trying to pay off your mortgage early, you may think it’s enough to just send extra money to the bank. Well, bad news, it’s not!
Have you heard this line before? “Make sure additional payments are applied to the principal and not to the following month’s mortgage.”
Banks actually want you to pay the full amount of interest that you would owe if you carried out your mortgage for the full loan term. So, as a ‘default’ some banks don’t apply extra payments in the most optimal way for you.
The most optimal way to apply your extra payments to principal. If you ask for payments to be applied toward principal, the banker may look at you like you’re crazy. My bank actually automatically applies payments to principal, but some banks do not, so be specific and persistent.
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What’s actually happening when you take out a loan
When you take out a loan, the bank assigns you an interest rate based on your credit score. You tell them how much and how long you need to borrow it for. Then the bank approves your mortgage based on your credit. If you need help building your credit, check out the 4 credit mistakes many people make, and how to fix them.
Interest, time and loan amount are the 3 inputs into a loan. The bank uses those to crunch the numbers and tells you how much you are going to pay each month.
When you make your monthly payment, a portion of that goes to interest and a portion goes to principal. Principal reduces the amount you owe the bank, the interest is money you pay the bank for letting you borrow.
Interest is calculated first. They divide your annual rate by 12 and multiply it times your total outstanding balance. That’s your interest.
Then they stuff the rest of your monthly payment with principal. So if you owed $400 in interest, and your monthly payment was $1000, then $600 would be applied toward your balance (this is the principal payment).
Next month, your amount owed decreases to the bank. So when they take your interest rate, divide it by 12, and multiply it by your amount owed, you now owe less in interest than you did last month.
To continue our example, in month 2, you now owe $399 in interest and $601 goes toward principal. But you still pay the same $1000.
The bank has done the math so that if you continue this over the life of the loan that you agreed to when you signed the papers, you will wind up at $0 owed in your last month.
When you make an extra payment and it goes toward principal
If you make an extra payment. So now you decide to make your $1000 payment and add an extra $500 toward the principal. This month, you pay $400 in interest and $1100 in principal.
Great Job—you’re doing exactly what I want you to do, to pay off loans fast. If you need some ideas for how to save money so that you can make extra payments, read my 18 ways to save money each month.
Next month, if you just met the $1000 payment, your breakdown of interest and principal would be different. This time, you now owe $398 in interest and $602 goes toward principal. That’s an extra dollar toward principal because you made the extra payment last month.
Now, you’d try to keep making the extra $500 payments and apply them toward principal, and you’d be paying less and less interest each month. Over time this really adds up, especially on long loans with large balances.
If you do this, you’ll see that your balance gets lower and lower, and the timeline to pay off the loan gets shorter and shorter.
When Banks apply payments to Interest First
If you make a payment and you don’t specify that it should go toward principal, some banks apply it to interest first. Remember when I said that the bank calculates interest that you owe each month, well that’s not exactly true.
The bank actually creates a schedule of how much goes toward interest and principal each month, called an amortization table. It works for any loan type, and you can check out a nifty calculator here.
The bank adds up the total amount of interest you would pay over the life of the loan, and the total amount of principal (the initial amount of money you borrowed) and that becomes your total loan balance.
When you make a normal payment (no extra), it applies toward the interest and principal as I explained before.
When you make an extra payment, if you don’t specify principal, it applies toward interest that you would have paid in the future. So in our example, in the second month you still pay $399 toward interest, and $601 toward principal, just like you didn’t make the extra payment.
Where did the money go? They assumed that you wanted to pay all the money that you would have paid if you took the entire life of the loan to pay it off with no extra payments. Including all of the interest.
You can imagine that they started counting interest that you would have paid on your last payment and paid that first, and then moved to your second payment, and keep applying your extra payment toward interest at the end of your loan.
Interest vs Principal: Example
I am better with visuals, so let me give it a shot.
Imagine you have a giant ball pit with green and red balls, green for principal, red for interest. You break up that ball pit into 360 sections (monthly payments on a 30 yr mortgage).
If you pay extra principal, you take one red ball out of each section, and replace it with a green ball from the last section, and you take all of the red balls out of the last section so that the last section (payment) is empty. You paid off your mortgage early!
If you pay extra and it is applied to interest, you just take the red balls out of the last couple of sections and fill them in with green balls. You’re not taking nearly as many total balls out of the ball pit.
So why does this matter?
In my example above, you may have been thinking, “great, I pay $500 extra and next month I only get one extra dollar applied to principal.” However, remember that you also don’t have to pay nearly as many interest dollars over the life of the loan.
Say you have a $100,000, 30-year mortgage at 4.5% interest. This mortgage payment would be $506 per month, and if you pay exactly that over the 30 years, you pay $182,405 total. That means you pay a total of $82,405 in interest.
If you pay interest first, the bank assumes you want to pay the full $82,405 in interest, but you will pay off your loan a little than 30 years. But that’s not the most optimal way. Instead, by paying principal first you can capitalize on some major savings, and save yourself time paying off the mortgage.
If you pay an extra $100 per month, you now pay monthly payment of $607. Over the life of the loan you now pay $156,028. That’s a savings of $26,376 in interest. Also, you’re finished paying the loan in 21 years, instead of 30.
If you pay an extra $500 per month, you now pay a monthly payment of $1,007. Over the life of the loan you now pay $125,339, and save yourself $57,065 in interest. Also, you’re finished paying the loan in 11 years, instead of 30 years.
What are you doing to pay off your mortgage early? Leave your answers in the comments below!