Q I want to start making extra principal payments on our mortgage every month. Does it make any difference whether I just send in any amount, like $30 or $100, or should I follow the amortization schedule and make advanced principal payments as shown month-by-month?
P.H., Everett
AMost mortgage payment coupons include a space where you can fill in an additional amount to prepay the principal balance of your loan. Most lenders allow you to fill in any amount you choose, as long as the payment is included with the regular monthly payment and clearly designated as an extra payment to reduce the principal. Check with your lender before making your first extra payment to see if they have any special restrictions.
Some borrowers like to make extra payments that exactly correspond to the principal payments on their amortization schedule because it provides an easy way to calculate how quickly the loan will be paid off. For example, by following this strategy, you could pay off a 30-year fixed rate loan in only 15 years.
But don’t think that you have to be that scientific about pre-paying the principal on your mortgage. Any amount you pay early will reduce the amount of interest you will have to pay over the life of the loan. Just remember that you get the biggest bang for the buck in the early years of the loan, when almost all of your monthly payment is going to pay interest expense.
For example, a $200,000 loan with 30-year fixed interest rate of 5.5 percent would have monthly payments of $1,135.58. Of the first payment, $916.67 would go to pay the interest and only $218.91 would be applied to the principal balance. Five years into the loan, on payment No. 60, the portion of the monthly payment applied to principal increases to only $286.71, with the remaining $848.87 going to pay the interest expense. As you can see, it doesn’t take much of an extra payment toward principal each month to dramatically speed pay-off of the loan compared to the normal amortization schedule.
Now, if you want to use the double-up amortization method to cut your loan term in half, here’s how you would do it. First, you need a printed amortization schedule showing all 360 monthly payments of your 30-year loan. If you don’t have one, there are many computer programs available that will print out amortization schedules, as well as online mortgage calculators on the Internet.
For example, let’s look at an amortization schedule showing the first four monthly payments of the 30-year fixed $200,000 loan at 5.5 percent interest described above. The regular monthly payment is $1,135.58:
1. Principal is $218.91 and interest is 916.67.
2. Principal is $219.91 and interest is $915.66.
3. Principal is $220.92 and interest is $914.66.
4. Principal is 221.94 and interest is $913.64.
You use the amortization schedule to determine the amount of each extra principal payment, and to keep track of these payments by writing in the date, amount and check number of each mortgage payment next to the appropriate payment number on the schedule. Each month, you double up your principal payments by adding on the principal amount for the following month, according to the amortization schedule.
For example, on payment No. 1, you would pay the regular loan payment of $1,135.58, plus the $219.91 in principal that would normally be paid on payment No. 2, so you would send in a total of $1,355.49 the first month and make a note next to payment No. 2. By paying that extra principal, you are saving the $915.66 worth of interest you would have paid on payment No. 2.
The next month, you would start at payment No. 3 on your amortization schedule because you have skipped payment No. 2 by pre-paying that month’s principal. You would pay the regular payment of $1,199.10, plus the $221.94 principal amount scheduled for payment No. 4, for a total payment of $1,357.52. Again, you would effectively save the $913.64 in interest that would have been paid on payment No. 4. Make a note of the payment next to payment No. 4 on the amortization schedule to keep track of your progress.
Because you are doubling up your principal payments, each month you skip a payment on the amortization schedule. By the end of the first year, you will be at payment No. 24 on your schedule, rather than payment No. 12.
Now, please don’t misunderstand. By “skipping a payment,” I am referring only to skipping down the amortization schedule to determine how much extra principal you should mail in each month. That does not mean that if you double up on your principal payment one month you can skip making your regular mortgage payment the following month.
Again, if this pre-payment method is too complicated, you can pay off your mortgage early by simply sending in an extra $30 or $100 each month with your regular loan payment, as you suggested. You won’t have the precision of cutting your loan term exactly in half, but you will still save tens of thousands of dollars in interest expense by paying off your mortgage several years ahead of schedule.
But remember, the savings projections assume you are holding the loan until it is paid in full. If you sell your home or refinance your mortgage before it is paid off, you will still save some money on interest expense, but the total savings will not be as large as if you had held the loan for the full term.
Mail your real estate questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206.Fax questions to Tytler at 425-339-3435 or e-mail him at economy@heraldnet.com.
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