Will Paying Extra on Your Mortgage Save You Money?
Paying off your mortgage early makes financial sense, so making extra mortgage payments is the way to go. Everyone wants to be debt-free as soon as possible, right?
But before you start sending money to your lender, there are some things you need to keep in mind. We'll go into detail and show what you can expect to happen when you make those extra payments.
How Additional Payments Affect Your Mortgage
There are two things that really matter when it comes to making extra payments on your mortgage:
- How much you pay
- When you pay
The truth is, most people think of their loan payments and the amortization schedules as a linear timeline. For instance, you may think an additional dollar now will be the same dollar down the road, but that isn't the case at all.
Don't worry, we've got you covered. We have, in detail, how all of this breaks down.
Let's look at an example to better illustrate this. Say you have:
- A conventional loan
- Loan amount = $260,000
- Interest rate = 4.52%
- Term = 30-Year
- Extra payments are made from the beginning (March 2018) through the life of the loan
|Additional Monthly Payment||Time Saved||Interest Saved*|
|$30||1 year 4 months||$11,406|
|$60||2 years 7 months||$21,574|
|$150||5 years 8 months||$46,457|
|$300||9 years 5 months||$75,713|
|$500||12 years 10 months||$101,505|
|$1000||17 years 10 months||$136,981|
|Data from: mortgagecalculators.info|
*Interest is rounded to the nearest dollar
Let's examine what an extra $30 will do, since that's feasible for most homeowners. In the grand scheme of things, you'll save $11,406 in interest and shed one year and four months off of your term (thus making it 28 years and 8 months). That's not bad for just an additional $30 with your monthly payment.
But pay close attention to what happens when you increase the amount. We'll compare $30 to $60. Most people would assume that, since 60 is double the amount of 30, it would save double the interest and shed off double the amount of time.
Instead, making that additional $60 payment is just shy of doubling. You save two years and seven months instead of two years and eight months, and the interest you save is $21,574 instead of $22,812. Each time you increase the amount, the less you actually save. This is called diminished returns.
Yes, it sounds backwards. We're used to the idea that the x-amount you put into something, you get the same in return. But it doesn't work that way with mortgages.
This is good to keep in mind when making extra payments, because you definitely don't want to overexert your finances and not get the same benefit in return.
When You Pay Affects How Much You Save
Now let's see what happens when you make an extra payment each month during specific periods of time.
|Extra $150 Monthly Payment||Time Saved||Total Interest Saved*|
|Years 1–5||1 year 10 months||$20,878|
|Years 5–10||1 year 6 months||$15,046|
|Years 10–15||1 year 10 months||$10,321|
|Years 15–20||11 months||$6,504|
|Years 20–25||9 months||$3,427|
|Years 25–30||5 months||$967|
|Data from: mtgprofessor.com|
*Interest is rounded to the nearest dollar
The table demonstrates completely different outcomes, even though each payment plan is the same (5 years of extra $150 payments). It really does matter when you plan on making extra payments if you want to get the best bang for your buck.
So far we've learned something that goes against our intuition (which tells us that the more you pay, the more you should benefit). But when it comes to your mortgage, you actually benefit more from making smaller payments. And the sooner you make them, the better.
This is because of compound interest. If you pay more sooner, you'll save more in the long run.
If this sounds like a great plan for you, make sure you write a separate check (or separate electronic payment) to your lender specifically stating that the extra payment is to go towards your principal. Otherwise, your lender might get mixed up and apply it to next month's interest.
It's best to not assume things will be handled correctly, so make sure your money goes towards your principal.
Things to Consider Before Making Extra Mortgage Payments
Wait! Before you start sending that money to your lender, make sure you're in a financial position to make the extra mortgage payments, because your money might be useful elsewhere.
- High Interest Rate Credit Card Debt – If you have credit card debt, it would make much more sense to send those extra payments to your cards rather than your mortgage. You'll save a lot more by doing this. Plus, you can usually deduct mortgage interest on your taxes, but you can't deduct credit card interest.
- Emergency Savings – If you don't have an emergency fund set up, start building this up before making extra mortgage payments. Most experts recommend having six months of living expenses saved up for a rainy day. You don't want to be in a situation where you've been making extra payments on your home only to be at risk of losing it. Always have a backup plan.
- Retirement Plan – Consider a 401(k), especially if your employer matches the contributions you make. Not taking advantage of matching retirement fund contributions is basically rejecting free money.
An Alternative to Extra Mortgage Payments
Another cost-effective strategy is to refinance into a shorter term. For example, say you have a total mortgage balance of $200,000 and you're two years into your 30-year mortgage. If you refinanced to a 15-year term, that could save you over $85,000 in interest plus the amount of time it takes to pay it off.
Shortening your term is like a forced savings plan, so make sure you're able to commit to this financially before pursuing it.
The Bottom Line
Now that you have the information you need, it's time to weigh your options. Making extra mortgage payments is definitely worth it and can save you a lot of money in the long run, but it's also important to consider how to make those payments and what else you could do with your money. There's no right or wrong answer, it just depends on what you want to achieve.