If you have been keeping up with the news about residential real estate in California over the last few years, you have probably heard a lot about the high amount of homes that are being purchased using all cash (especially with regards to the Bay Area and parts of LA). While this may be great for the 1% that can afford to do so, the reality is that most Americans purchase their home using some type of mortgage. Hopefully, when you obtained your loan from the bank or credit union, you shopped around smartly and did not get a loan that you could not comfortably afford. In the ideal situation, your monthly payment is low enough that you have money you can set aside every month to either save or invest. With home prices in Ventura County still on the rise, this is getting harder and harder to do, but there are still plenty of people who may have bought their home when prices were much more affordable. If this is you, you may be considering whether you should put extra money into your monthly mortgage payment to pay off your loan early. Today, we will look at some of the effects that paying extra principal payments can have. But before we do so, let’s first examine how your monthly payment is calculated.
Calculating your monthly payment
For simplicity’s sake, we will use a 30-year fixed-rate loan with 5% interest in this example and the median home price in Ventura County of approximately $620,000. Your monthly payment can then be calculated using the following equation.
M = P [i(1 + i)^n ] / [ (1 + i)^n – 1]
Where “M” is your monthly mortgage payment, “P” is the initial amount of your loan, “i” is your monthly interest rate, and “n” is the number of monthly payments you will be making. If you enter in the numbers above as the variables in this equation, you will come out with the following
M = 620,000[0.004167(1+0.004167)^360] / [(1+0.004167)^360-1]
M = $3328.29
Fortunately for everybody, there is an easier way to determine what your monthly payment will be. If you plug the same numbers into an amortization schedule calculator, you will see that it calculates the same monthly payment for you. Now that we bored you with how the math works, we can now discuss what making extra mortgage payments will do for you.
Making Extra Mortgage Payments
As I am sure most of you know by now, the bulk of your monthly payment during your first few years actually go to paying interest while very little goes to paying down the principal balance. Conversely, towards the end of your loan, most of the monthly payment is going towards the principal while very little is going towards interest. If you were to see the monthly calculations on our example loan from above, you would see that your first monthly payment would have $2583.33 of interest while your last monthly payment would have only $13.82 of interest. Below I have built a table showing what the effect is of paying off more of your mortgage each month.
|Monthly Payment||Extra Monthly Amount||Time to payoff Mortgage||Total Interest Paid|
From this table, you can clearly see that by increasing your monthly payment, the amount of overall interest you will pay on your loan decreases as does the length of time that it will take you to pay the loan off. Obviously, paying less interest is usually a good thing. But there is another factor that may not stand out in the table above. Let’s look at another table where we increase our monthly payments by a factor of two each time.
|Monthly Payment||Extra Monthly Amount||Time to payoff Mortgage||Total Interest Paid||Total Interest Saved|
|$3328.29||$0||360 months||$578,187.85 0|
If you look at that table carefully, you will see that by doubling the amount of your extra payment per month, you do not double the amount of interest that you save over the life of the loan. In fact, for each extra dollar that you put into your monthly payment, you realize less and less benefit per dollar. This is known as diminishing returns and should be taken into account when you consider what it is that you want to do with the money.
Should you make extra mortgage payments or not?
As we have said in some of our posts before (and will say many times in the future), it all depends. If you have access to a financial planner, either through your job or speaking to one on your own, they should be able to help you lay out your goals and a roadmap for achieving them. While it is not a bad thing to make extra mortgage payments, you may get better bang for your buck by investing that money elsewhere, especially when you start talking about a significant amount of extra money per month. But as you can see from our last table above, even a “smaller” extra payment can make a big dent in the amount of interest you save. And what is not shown in the tables above is that the earlier in the life of your mortgage that you start the extra payments, the more savings you will reap. When all is said and done, if you do have extra money per month and all you’re doing it is putting it in a savings account with no real purpose, you may want to consider making extra mortgage payments and saving yourself more money in the long run.