With your new home comes a mortgage and many years of monthly payments. You may notice that a large portion your payments goes to pay interest on the loan and only a small amount to pay down the loan balance. Paying a little extra each month increases the amount that goes to pay down the principal, increasing the equity in your home. But paying early doesn't save you a thing. An understanding of how a mortgage payment is calculated will help you formulate a plan to increase your equity faster and cut your total interest expense.
Your mortgage payment has been calculated to determine equal monthly payments to pay off the loan in the selected term. The amount of interest due is based on the mortgage interest rate and the outstanding loan balance. As a result, the monthly interest paid is high in the early years of a mortgage and the payments are primarily principal in the later years. If the monthly mortgage payments are made as scheduled in your mortgage contract, the amount of principal and interest paid with each payment will match the amounts listed on the payment schedule.
Interest Calculation and Payment
You can calculate the interest to be paid on your next monthly mortgage payment by multiplying the monthly interest rate times the outstanding mortgage balance. The monthly interest rate is the annual rate divided by 12. Once this interest for a monthly payment is determined, that is the amount of interest that will be charged. It does not matter on which day the payment is received. Paying your mortgage early does not save on the interest due for the month.
Reducing The Monthly Interest
The only way to reduce your overall interest expense is to add extra principal payments to your minimum mortgage payment. Your mortgage payment slip will have space to enter extra principal and you can increase the amount of your house payment check by the extra principal you want to pay. The power factor of paying extra principal is that each payment of extra principal reduces the interest due on every payment for the remaining term of the mortgage because you will owe a little less on the total loan. The result is more principal paid with each payment and the term of the mortgage is shortened.
Alternative Mortgage Type
Another type of mortgage -- often called a simple interest mortgage -- calculates interest on a daily basis. With this type of loan, making the payment early does save on interest and late payments increase the interest, extending the term of the loan. Simple interest loans are usually combined with a bi-weekly mortgage payment plan. These plans -- if followed -- pay of the balance in a shorter amount of time than it would take to pay off a typical 30-year mortgage making only the minimum payments. Only a small percentage of mortgages are of the simple interest variety.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.