Many myths and "hacks" surround paying off a home faster, but the reality is that consistent effort and understanding how your mortgage works are key. This article outlines practical steps you can take to reduce your mortgage term and save on interest.
Understanding Principal and Interest
Your monthly mortgage payment consists of two main parts: principal and interest. With a fixed interest rate (which is generally recommended), the total monthly payment remains the same throughout the loan term.
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Principal: The original amount of money borrowed.
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Interest: The cost of borrowing the money.
Calculating Interest
While calculating the principal portion of your payment involves a complex formula, understanding how interest is calculated is simpler. To determine the interest paid in a given month:
- Multiply the outstanding loan balance by the annual interest rate.
- Divide the result by 12 (for each month of the year).
The resulting number is the interest portion of your monthly payment. The remaining amount goes towards the principal. As you pay down the principal, the interest portion of your payment gradually decreases, and more of your payment goes toward the principal. This trend accelerates over time, particularly in the later years of the loan.
The Importance of a Low Interest Rate
Securing the lowest possible interest rate is crucial. Even a small increase in the interest rate can significantly increase the total amount of interest paid over the life of the loan. For example, increasing from 3% to 4% can lead to a substantial increase in total interest paid. So, remember to look at the interest and compare between lenders.
Practical Strategies for Faster Mortgage Payoff
Bi-Weekly Payments
A common strategy is to make bi-weekly payments (half of your monthly payment every two weeks). This effectively results in making one extra month's worth of payments per year, accelerating your payoff and reducing overall interest. Instead of making 12 payments, you make the equivalent of 13.
You can achieve a similar effect without changing your payment schedule by simply making one extra full payment each year. Or by dividing your monthly payment by 12 and adding that amount to each monthly payment.
Making Extra Principal Payments
Another effective strategy is to make extra payments directly toward the principal balance. Even small additional payments can significantly reduce the loan balance, leading to lower interest charges and a faster payoff.
For example, an extra payment of $5,000 can potentially save almost a year's worth of interest. Use an amortization calculator to estimate the impact of extra payments.
The Importance of Budgeting
To make extra payments, you need to have the financial flexibility to do so. Buying a home within a manageable budget (where the maximum ratio is 50% of your income) is essential. This allows you to allocate extra cash towards your mortgage.
Life events and unexpected expenses may occasionally disrupt your plans, but you can always resume making extra payments when you are able.
Considering a 15-Year Loan
A 15-year mortgage typically has a higher monthly payment than a 30-year mortgage, but it significantly reduces the total interest paid and shortens the loan term. The interest rate is also usually lower on a 15 year mortgage.
With a 15-year loan, the principal balance decreases at a much faster rate.
If you cannot afford a 15-year mortgage initially, you can still adopt strategies to accelerate your 30-year mortgage payoff.
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Passive approach: Make the one extra payment per month or year as described above.
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Aggressive approach: Make additional payments on top of your regular payment when possible.
Aim for making an extra three months of principal payments per year. You can achieve this by dividing your principal and interest amount by 12 and saving this amount each month to make the extra payments.
Understanding Amortization
Don't be intimidated by your amortization schedule. Understand how it works, and make a diligent effort to make extra payments. Even seemingly small extra payments can have a significant impact over time. These extra payments will reduce your principal faster, and that will reduce the amount that you pay in interest.
Paying extra money towards interest does not get you money back when you sell the house. It only lines the bank's pockets. Therefore the faster you lower your principal, the more you could potentially make when you sell the house.