Prepay your next month's principal, and you could pay off a 30-year mortgage in 15 years in many cases
Thanks for the A2A. I am currently prepaying principal on a home that I own. Many of the answers here are factually accurate but let’s see if we can explain it in a clearer way.
Simply put, You can pay your home off faster if you are willing to send in a bigger payment every month. The book states that you are ‘not paying extra money’ which can be misleading. You are definitely taking more money out of your checking account every month now in exchange for having your house paid off many years earlier.
If you can afford a bigger payment, this can be done in two ways:
- Follow the method in the book. As Greg Ryan points out, the book does not clearly state that you’ll have to adjust each and every payment for this method. It pays off your home but is also a lot of hassle every month. You can calculate the proper amount for your home using this Prepay Calculator.
- If this sounds like too much hassle to you (as it does to me), try this instead. If you can afford, for example, $300 more per month, just add it to your monthly payment each time and forget about it. The bigger check will help you pay off your mortgage many years faster. If you want to know exactly how fast and how much money you can save, use this Extra Payments Calculator.
I understand the confusion on this page of the book. Simply put, you only pay interest on the home loan balance that you owe. As you send in extra payments, the amount of interest you pay decreases because you owe less money for your home (or car or credit card). These savings add up quickly.
The above calculators can help you see how much faster and how much money you can save. If this isn’t clear, please feel free to ask questions in the comments.
To understand fully how this system works, you have to know that interest rate is calculated based on your outstanding loan balance and not on your monthly prepayment.
The aim of making prepayments on your monthly principals is to, first of all, reduce the loan balance before next month’s interest rate is calculated.
A 30 years’ mortgage for $40,000 with 5% interest would translate to an interest of $37,302.31 without any additional payments. But with an added payment of $100, the total interest to be repaid will be reduced to $17,078.06 and most importantly to 15 years instead of the original 30.
In the first month, the total sum paid - $214- goes to the principal plus the interest account while $100 goes to the additional payment. This means that after the deduction of the $50- the main monthly payment- the-additional $100 will be deducted again from the loan balance of $39,050 remaining $38,050 to be used for calculating the interest unlike the $39,050 that would have been used without any additional prepayment of the principal.
Though the difference may seem small but with repeat prepayment every month, a substantial amount would be saved in the payment of interest.
With this additional monthly principal repayment, the principal on which the interest rate is to be calculated will be reducing at a much higher rate than if there is no additional prepayment on the principal.
In the first month of the mortgage, with the additional payment of $100, the total of $314.73 will be the total sum of the mortgage. $214.73 would be the standard monthly payment while the extra payment of $100 will be deducted first from the loan balance before the interest rate is calculated in the following month. As a result of this, the interest will be reducing even though this doesn’t change the principal amount.
Taking a look at the schedule prepared below, you will realize that the time to be used for the total payment of the mortgage would be reduced to 15 years.
However, borrowers who want to pursue this option need to know that it will come with additional financial commitments every year. Therefore, before committing to additional payments on your principal, ensure you have analyzed all other necessary commitments.
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