How Mortgage Overpayment Is Applied?

Paying more than your minimum mortgage payment is a practice that can save you big bucks down the road. Each time you overpay, you reduce the total amount of interest you will accrue over the life of the loan as well as shortening its term. This strategy isn’t for everyone, so take a good look at your income and expenses before heading down this road.

The interest calculations on your mortgage are different from most other types of loans. Instead of computing interest daily, mortgage lenders only calculate interest on the first day of the month -- assuming you make your payments on time. They base their calculations on the amount of outstanding principal on that day and then determine how much of that payment goes toward principal and how much goes toward interest. During the first few years of the mortgage, when the bulk of the principal balance is still outstanding, most of your payment is applied to the accrued interest. Toward the end of the mortgage term, the majority of your payments go toward principal.

When you pay more than the minimum mortgage payment, the lender applies the additional amount to your outstanding principal balance. This reduction in principal helps you to build up equity in your home more quickly and reduce the amount of interest you will pay over the life of the loan. Your payments will not change if you have a traditional mortgage, but the allocation of money toward principal and interest will change drastically over time if you continue to pay more than is due.

There are several different techniques that people use to prepay some of their mortgage principal. High-level executives and people who receive large bonus checks once per year often make one additional payment toward their principal. On a 30-year fixed-rate $200,000 mortgage at 6 percent interest, making one additional $5,000 payment toward the principal each December will cut the length of the mortgage to less than 13 years and will save over $44,000 in interest. On that same mortgage, paying an additional $50 each month will reduce the mortgage term by five years and save you more than $13,000 in interest payments over the life of the loan.

Before you start paying additional amounts on your mortgage, check with your lender to be certain you will not be subject to any prepayment penalties. Most of these penalties only apply to borrowers who pay off the entire loan in the early years or who pay more than 20 percent of the balance in any given year, but it is still worthwhile to check. Compare the interest rates on other debt to your mortgage interest rate. If those other debts have a significantly higher interest rate than your mortgage, you should pay those off before starting on a mortgage prepayment schedule.