Sunday, July 27, 2008

query: what happens if you pay part of your mortgage early

This is a great query. First, let's set aside prepayment penalties because they are rare and also because they are unique. If you have a Note that includes a pre-payment penalty, read those terms carefully for any impact on partial pre-payments. Okay, now for your query.

Fixed Rate Mortgages: These mortgages have a level mortgage payment going towards principal and interest. The total remains the same every month, BUT the amount going towards principal versus interest changes as the principal balance is reduced. Here's an example for comparison:

Let's take a $100,000.00 mortgage at 6% for 30 years - $599.55 is the P & I total monthly payment.

You calculate the amount of the payment going to interest by taking the unpaid principal balance times the interest rate and divide that figure by twelve. So, your very first monthly payment will work out like this:

100,000.00 multiplied by .06 divided by 12 = 500.00, so 99.55 is going to principal, see?

So, the next month, if you don't make an extra payment, the new unpaid principal balance is 99,900.45, so let's do the math again.

99,900.45 multiplied by .06 divided by 12 = 499.50, so how do you know how much is going to principal? Take the total P & I payment of $599.55 and subtract $499.50 which leaves $100.05 going to principal. This is how the lender's computer will recalculate your balance every month.

Now, what happens when you add an extra payment towards principal? Let's say you decide to send in an extra $100 in the third month. So, we know the principal balance going into the third month is 99,900.45 less 100.05 = 99,800.40, right?

So, you send in a total monthly payment of $699.55 which includes your normal P & I payment of $599.55 and the extra principal payment of $100.00. Let's figure out how much is owing for interest.

99,800.40 multiplied by .06 divided by 12 = 499.00

$699.55 less $499.00 = $200.55 With this pre-payment you will reduce the principal balance to $99599.85. Are you with me?

Now let's calculate the interest for the next month by taking 99,599.85 multiplied by .06 divided by 12 = 497.99 - that's not a super reduction by this type of reduction builds over time and before you know it, you're really chopping down that principal. If you paid an extra $100 towards principal on this mortgage every month, you'd reduce the remaining number of required payments from 357 to 250. Compare that:

357 multiplied by 599.95 = 214,182.15 versus

250 multiplied by 699.95 = 174,987.50

That's a savings of 39,194.65 and a much earlier mortgage payoff. Anything extra you pay in towards principal will impact the monthly interest cost and create a synergistic savings and early mortgage payoff. I say paying extra towards the principal is money well spent and the eventuality of NOT having a mortgage - or any debt, if possible, is REAL freedom. Yeah, I know that lots of financial analysts will disagree. I'm not about financial analysis. I'm about personal freedom and less butterflies in the belly and sleeping well at night and all that good stuff.

Adjustable Rate Mortgages do work differently with partial prepayments. You will still have the same type of calculations of interest, however, because an ARM readjusts the payment periodically, the payment will not stay level. The payment will reduce and adjust to the original maturity date, so with an ARM, you should still work to pre-pay and pay as much as you can extra, just realize that since the payments are not level, you'll have to re-work figures each time the payment recalculates to make certain you are on track with your planned payoff.

Whether you are planning for retirement or simply craving personal freedom, I highly recommend reducing all debt as quickly as you can. That doesn't mean you should never borrow. It really means that you should use borrowed money or any money, frankly, as a tool but don't let the tool enslave you. Get it?


Chelle said...

You really did a good job of explaining what happens when you pay off your mortgage. I agree borrowing money needs to be done carefully - in some ways it can help you, in others it can trap you.

Diane Cipa said...

Thanks, Chelle.