One of the oldest tricks in the book for saving money on a home loan is to make a single extra mortgage payment per year. The idea was pushed so aggressively in the late 1990s and early 2000s that it took on an almost mythical status. But the idea itself is not a myth. It really works.
Perhaps you’ve heard about it but are not clear about why it’s such a good idea. Keep reading as this post will clear things up for you. Also be aware that the idea applies to all sorts of mortgages. It works for VA loans, conventional loans, HUD loans, etc.
What Your Mortgage Payment Covers
If you own a home you purchased with a mortgage, you are making monthly payments to your lender. You probably have a 15-, 20-, or 30-year mortgage. You will keep making monthly payments throughout the life of the loan until it is completely paid off. But what do those payments cover?
The two biggest components of your monthly payment are mortgage principal (the amount you borrowed) and interest. After that, your monthly payment also covers:
- Additional costs rolled into your mortgage.
- Insurance and taxes (under escrow).
- Private mortgage insurance (if applicable).
The idea of making an extra mortgage payment per year is rooted in the goal of reducing the principal. That is key to understand. When you make an extra payment, you need to instruct your lender to apply the entire amount toward your principal. None of the payment should go to cover any of the other things.
Loan Terms and Interest
By now you might be wondering why it is a good idea to make an extra mortgage payment per year. It’s all about loan terms and interest. Every year, the amount of interest you pay is determined by the outstanding principal balance at the start of the year. So an outstanding balance of $100,000 at 5% would equal $5000 in total interest.
Every regular mortgage payment you make reduces the outstanding balance by a certain amount. Reducing the outstanding balance reduces the total interest you pay for the coming year. By making an extra mortgage payment every year, and applying that payment to principal only, you are paying the outstanding balance faster. That means you are paying less interest.
By the way, the amount of time you have to pay your loan and your payment schedule are known in the loan industry as terms. The terms on a typical home mortgage are 30 years, with payments monthly. The longer the terms, the more interest you pay.
How You Save Money
This still might be challenging to understand, so let’s look at a fictional scenario. Let us say you took out a 30-year mortgage at 5%. If you don’t make any extra mortgage payments, you will ultimately make your final payment 360 months after your first payment. Twelve months per year multiplied by 30 years equals 360 months.
Now, let’s say you make one extra mortgage payment per year. Every 12 years, you knock an additional year off your original terms. Instead of taking 30 years to pay your mortgage, you’ll pay it off in 27.75 years. That is 27 months earlier than planned. Doing so also means you are not paying interest for those 27 months. That could potentially save you thousands of dollars.
Making all this work for a typical home mortgage is predicated on applying the extra payment exclusively to the principal. So if you are going to do it, and you should, make sure your lender applies the payment to your principal only.
If you’d like to consult with us about your future home mortgage or loan, schedule an appointment with us today.