It’s amazing how surprised people usually are to find out how much an extra $20 payment may save them on their loan in the long run. For example, a $100,000 30-year mortgage bearing 9 percent annual interest calls for monthly payments of $804.62. Suppose a borrower could afford to increase the payment amount by $20 to $824.62, and the lender does not charge prepayment penalties. By making the larger payment each month, the borrower would save $24,135.56. No, you didn’t misread the amount. An extra $20 a month results in roughly $24,000 of interest savings!
Here is our little manual on how to work your own miracle.
First of all, the topic you absolutely must discuss with your mortgage lender is the treatment of extra payments towards principal, because some lenders tend to include a penalty clause regarding extra principal payments in the mortgage. If your credit score is not particularly high, you will very likely have a mortgage loan with a higher-than-average interest rate, and you may be penalized if you try to make extra or early principal payments on the loan.
If your lender allows you to make extra payments – it is action time! Get a good on-line calculator (or download a more universal one from here) and take a look at the amazing amount of money you can save by simply making one extra payment a year, or by altering the pace at which you make your payments. A fine example is a biweekly mortgage. Well, not so much the biweekly itself, but its rival and equally efficient alternatives based on conventional mortgage loans and extra payments towards them.
I will not tire you with more numbers and examples here, you can marvel at the sums and the savings the calculator reveals to you yourself. I will only try to explain how these things can be accomplished, assuming your mortgage carries no principal extra payment penalties.
If you have a Fixed Rate Mortgage, the amount of your monthly payment is fixed throughout the life of your loan. Extra payments towards the principal make such a loan amortize sooner altogether, but they do not affect the amount of your monthly payment, they only change its structure. Let me remind you, that each Fixed Rate Mortgage monthly payment includes a certain amount that pays the interest and the rest goes to the repayment of the principal. Even though the total amount is fixed, the proportion of these two elements can and does change. Once you’ve paid something extra towards the principal, it decreases, which means that the amount of interest due with the next payment is lower, which, in its turn, means that the principal/interest balance of the monthly payment will shift: the amount paid towards interest will become smaller, which leaves more money to be paid towards principal. More to the principal > next payment’s interest part shrinks > more to the principal. This, by the way, is the natural scheme of a Fixed Rate Mortgage repayment plan, but extra payments always give it a neat boost – things move faster and the loan’s balance hits zero a lot sooner, if you cared to pay sound (I certainly don’t mean huge!) regular extra amounts. If your loan gets to be amortized in 24 years rather than the original 30, you realize how much the 6 avoided years of interest payments just saved you.
With an Adjustable Rate Mortgage, however, you will find that extra payments do affect the amount of your monthly payment. The period payment gets recalculated on the new principal and adjusted to the new rate on the rate adjustment day, stated in the contract. If your Adjustable Rate Mortgage has an initial, say, 5-year period of fixed rate, even with extra payments made during this period, the monthly payment will remain unchanged till the first rate adjustment.
The only type of mortgage whose monthly payment responds to an extra payment practically immediately is an Interest-Only Mortgage. Or so it should be. A lot of borrowers, however, complain that in reality this does not seem to be the case. Some lenders find it too much bother recalculating the payment every month, so they wait until an anniversary month to apply all the changes. Well, it is not bad either, and in month 13 (the anniversary month) you may be pleasantly surprised to see the adjusted amount of your monthly interest-only payment – since the interest due has been lower all since the extra payment(s), a part of the monthly payment has been credited to the principal. Still, if your goal is to have your payment decrease straight away – ask for this feature explicitly.
Thus, two main things to consider when deciding for an extra payment:
- Make sure there is no penalty for extra payments towards the principal;
- Find out about alternative investments – interest rate, taxes.
Let me explain the second one. Your loan’s interest rate is the key to how much extra payments can save you. Actually, any investment’s interest rate is the key to how much return you can have on your money. So, you may want to try and find some other than the mortgage option(s) to invest the money into and gain a better return. It may so happen that you own a business and the money invested into it will return 15% as opposed to, say, 9% of your mortgage interest rate. Or a bank deposit can sometimes have an interest rate higher than the rate of your mortgage. Investments with a higher rate of return look immediately more attractive, and can, in fact, be more profitable, but the tricky thing to always bear in mind is the tax deductibility of the mortgage interest payments as compared to the other option’s relationship with taxes.
