It’s difficult to project what your situation will be 15, 20 or 30 years in the future, but that is exactly what you should do before signing on to a mortgage. The good news is that regardless of the type and term of the mortgage you take on, you can make extra payments if your financial situation improves. Those extra payments will reduce the life of your loan and the amount of interest you must pay.
How Mortgage Payments Work
With amounts determined by a process called amortization, a portion of each scheduled payment that you make on your mortgage goes towards interest and the rest goes towards paying down the principal balance. Each month, the lender recalculates your loan, taking the old principal balance minus the amount from your last payment that applies towards the principal. Although your total payment amount does not change, the amount that is applied towards reducing the original loan balance increases with each payment, while the amount of interest you pay decreases. One exception to this rule is with adjustable-rate mortgages, where your payment may increase or decrease if the loan’s interest rate changes.
Double the Principal
Doubling the amount you pay towards principal by adding an optional additional amount each month can reduce the length of your mortgage by almost 50 percent. It is much easier to come up with the extra amount early on in the mortgage, when a large percentage of your payments goes towards paying interest and only a small amount goes to principal, but even if you adhere to this schedule for just the first few years, it will help to shorten the number of years you pay on a loan and reduce the amount of interest you pay.
If your income includes a hefty annual bonus or commission, or if you usually receive large tax refunds, even one extra payment per year can have an impact on how quickly you pay down your mortgage and build up home equity. If you have a $200,000 mortgage over 30 years at a 6.5 percent interest rate, even one payment each year of $1,000 will shave almost five years of payments off the length of your loan and reduce the amount of interest you pay by almost $47,000.
If you find yourself the recipient of a financial windfall, consider applying some of the money towards your mortgage. A good-sized one-time payment against principal will help to pay off the loan early and save on interest, but this is more beneficial early on in the mortgage. On a 30-year, $200,000 mortgage at 6.5 percent interest, a $10,000 payment applied at the end of year five will result in a savings of over $35,000 in interest payments over the life of your loan. The same payment will save you roughly $15,000 if it is applied to your mortgage at the end of year 15, and it will save you only $3,500 if you make this payment at the end of year 25.
Before You Write the Check
Look at your entire financial situation before making additional mortgage payments. Paying down high-interest credit-card debt, for example, should be one of your first priorities. Talk to a financial advisor before making additional mortgage payments if your mortgage has a pre-payment penalty clause. Use an online mortgage calculator like BankRate.com's (see Resources) to find the scenario that works best for you. If you have a low interest rate on your mortgage, it might work out better financially to either invest the money or pay off any debts you have that are accumulating at a higher interest rate.
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