Perhaps one of the hardest things to understand is an amortization schedule. In setting up a mortgage people talk about things like points, prepaid interest, principle payments, and other aspects. There are companies out there that claim they can switch you to a 26 week mortgage payment (for a fee) and save you thousands. Unfortunately, this lack of understanding makes people pay thousands more than they need to on a mortgage. Here are some things to know before you sign on the dotted line.
Avoid the 30-year mortgage if you can
Perhaps the worst mortgage in existence (assuming you don’t live in California where they have 50-year mortgages) is a 30-year mortgage. If one faithfully pays the monthly payments it will take about 20 years to reduce the balance of the mortgage by half. The reason is that in the beginning the whole value of the house is owed, so the amount of interest that builds up each month is large – most of the payment. As the mortgage is paid off the interest that builds up is less and less, meaning that the payment includes more and more principle – you’re paying off the house and reducing the loan balance faster.
Pay more early – you’ll save on interest later
The trick to saving thousands is to pay more at the beginning. Making extra payments during the first few years of a mortgage will takes years off of the schedule. Given that each year’s payments will be $10,000 or more, this would mean saving tens of thousands of dollars. Making extra payments at the end will make little difference.
A good way to do this without a lot of math is to look at your mortgage statement and study the principle and interest that was paid during the previous month. The amount of principal that is paid during the current month will be slightly more than the previous month. Likewise, the amount of interest paid will be slightly less (since the total of principal and interest adds up to the payment, which is constant). For example, assume a $1000 payment was made, of which $50 was principal and $950 was interest. The next month the balance due would be reduced by just $50, despite the $1000 payment. During the next month, $55 might be principal and $945 interest.
Putting a plan into action
So how do you put this information to use? If you pay an additional amount the next month equal to the principal amount from the previous month, you will be reducing your payment schedule by one month. In our example, instead of sending in $1000, send in $1050. By adding just $50 to your payment, you have avoided one $1000 payment. That $50 has just saved you $1000! When looking at things that way, it gets a lot easier to pay extra. If you could pay an extra $1000, you would take almost 20 payments, or almost two years off of your mortgage. This would be a savings of about $20,000!
As the mortgage starts dwindling the amount of principal paid off with each payment will increase and the interest decrease. During the last few years your payment may be $950 in principal and just $50 in interest. At that point extra payments make little sense since paying an extra $950 will just save you $50. Sending extra cash to a mutual fund or stock account may make more sense when the mortgage is only a few years from being paid off.
It’s easiest to pay more when it does the least good
Sadly, as with all things, you’ll probably have a bigger income near the end of your mortgage and be more able to make extra payments than at the beginning. The same holds true with savings where the amount you invest when you are young with a low-income makes a lot more of a difference than what you invest when you are old with a high income. Luckily though, even if you are only able to send in an extra $50 per month at the start of a mortgage, it will make a big difference.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing