The Impact of Prepaying your Mortgage Principal Each Month

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Home MortgageThe Bankrate.com Mortgage Calculator is one of the most valuable tools I’ve found to help you calculate the impact of prepaying your mortgage each month.  You can plug in different scenarios for your mortgage and it spits out a full amortization table in a matter of seconds.  It also helps highlight the value of prepaying your mortgage principal each month.

Most people dutifully pay the normal amount on their mortgage coupon each month and aren’t even aware that they can also voluntarily send additional principal payments each month.  These principal payments will decrease the amount of interest you owe on every subsequent mortgage payment and shorten the term of the mortgage, so there’s significant value in prepaying.

You don’t need to sign up for any of those fancy programs banks offer (for a fee of course) where you make one extra payment each year or you pay a portion of your mortgage every two weeks; just send a small amount of additional principal each month with your payment and you’ll be amazed at how much time it cuts off the back end of the mortgage term.

Pre-Payment Example

Here’s an example:  Let’s say you take out a $200,000 mortgage at 4% interest in August 2013.  Your monthly principal and interest component is $954.83 and you’ll pay off the mortgage in August 2043 and you’ll pay $143,739 just in interest alone over those 30 years.

If you started paying $100 in additional principal right from payment #1 you’ll pay off the loan in September 2038 and will pay $116,884 in total interest.  So, sending $100 extra a month, which you won’t really feel in the course of your life, will save you nearly 5 years in total payments and $26,855 in interest!

If you decided to start paying $200 in additional principal from the outset, you’ll pay it off in March 2035 and will pay just $98,810 in total interest.  This cuts off 8.5 years from your original term and $44,929 in total interest.

Some financial gurus out there will say that this is a bad idea; since you’re only paying a tax-deductible 4% interest rate and you could surely do better than that in the stock market over the long-term.  While that’s probably true on some level, this is a nice strategy to ensure you’ll save this money, which otherwise could get frittered away on miscellaneous garbage since it’s “only” $100 a month.

Mentally it’s wonderful to be able to pay off your mortgage 5-10 years early while still having the flexibility to stop these additional payments at any time.   There are some people who desperately want to pay down their mortgage as quickly as possible by paying many hundreds of dollars extra a month; while I’m not a proponent of that, I think paying $100-200 extra a month is a valuable part of a diversified investing strategy where you’re guaranteeing yourself a set return and some peace of mind.

We’d love to hear your thoughts on prepaying your mortgage, so be sure to comment below…

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Comments

  1. I think accelerating the payoff is great. I’ve been doing between $100 and $200 a month depending on things like real life. I am going to step up to about $250 for an even quicker payoff. I want to do more but I am going to put the different into a sorely needed emergency savings plan.
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    Reply

    • Mike,
      I absolutely think that your emergency savings plan is essential before you start stepping up the mortgage payoff! I would always tell people to get rid of credit card debt and have a healthy savings account before they even think about paying off their mortgage early.
      If you’re at the point where those things are locked down and you’re looking for ways to invest, it isn’t a bad idea to pay some additional principal on your mortgage. Of course this should only be a small portion of your additional money, as you can almost certainly get a better return in the stock market, but the psychological benefits of paying down the mortgage, combined with a guaranteed return make it fairly attractive.
      Thanks for stopping by and commenting — we really appreciate your input!

      Reply

      • Brad Thanks for your reply. I want to be receive interest rather than paying it out. I’m putting my foot into the water of investing again with a small P2P account. While I would love to pay off the mortgage first, the emergency savings plan is getting the higher priority When the ESP reaches at least three months income I’ll feel more comfortable about continuing on to a 6 month level along with the mortgage pay down. After the 6 month figure is reached a little more investing will surely follow.
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  2. I’d caution folks to check on their terms with their lender before just sending in some extra. One of my lenders would apply the extra to the next payment – unless you sent it to a separate address, or put a special note in the memo field of the electronic check. I ended up pre-paying 7 months of payments before I realized this! You might need to do something special to apply it to principal.
    Mom @ Three is Plenty recently posted…Saving Money with Baby – Cloth DiapersMy Profile

    Reply

    • That is a really great point — thanks for commenting! Honestly, I’ve paid additional principal on nearly 10 years of mortgage payments with at least 3 different mortgage companies and I’ve never had an issue, so this slipped my mind. I’ve heard many horror stories about this, so it is absolutely essential that you check the mortgage company’s math to see if they are applying it properly.

      It should be as simple as looking at your mortgage statement for the principal paid column, to see if your nice round number ($100 or $200 for instance) shows up as a distinct line item. I know this is how Wells Fargo treats their additional principal payments.

      If you can’t figure it out quickly, just give them a call!

      Reply

    • Hi Amanda,
      That sounds like a good goal! I’ll check your post out shortly…
      Like I mentioned above, this is a nice idea if you have everything else sorted out and are looking for a variety of ways to invest. I know a lot of people feel strongly either way about prepaying, but I really do think there’s value there if you’re reasonable about it.
      Thanks for stopping by!

      Reply

  4. When I was young, my mom would show me how much prepaying mortgages save on interest. My parents took out a 30 year mortgage but paid off their home in less than 20 years thanks to aggressively prepaying, especially at the beginning.

    Reply

    • It’s pretty neat to look at the amortization table with and without the additional prepayment, right? Each and every payment is “more valuable” (less interest owed) because of your additional principal. I find it cool to see the interest portion go down by a few dollars each payment…

      Seeing this mortgage table and the generic compound interest table are two of the things that impacted me most in my early financial learning process. I had a summer internship with Smith Barney one year in college and I remember sitting down with an IRA calculator and realizing you could be worth millions of dollars when you retire if you just save a few thousand a year that them compound over a 40 year period!

      Reply

    • That’s fantastic your mortgage company doesn’t charge you a fee and sets this up with my problem. I grabbed the following quote from a Bankrate.com article, “Biweekly payment programs are easy, but the convenience comes at a cost. Many lenders offer two ways to pay: upfront or as you go. Of the top five mortgage-servicing institutions, four charge enrollment fees that range from $295 to $379. Three also levy additional charges on every transaction.”
      So many big mortgage companies charge their customers heavily to sign up for this “convenience”, which seems absurd to me…

      Reply

  6. Hi Brad, new reader here. Great post- I am totally onboard with the concept of prepaying a mortgage and plan to aggressively do so once I settle down permanently. However, right now we are living in our “starter home”- a townhouse that we plan on living in for a total of 10 yrs max. We are currently in our 3rd year- so we would only be living here another 7 years, if that. Would you still recommend prepaying the mortgage in our scenario? Thanks!

    Reply

    • Hi Mellee,
      Thanks for the comment — I’m glad you found our site! That’s a great question; my general advice would be that it depends on your personal situation. I know that’s not an easy, satisfying answer, so let me elaborate: clearly if you have credit card debt, pay that first. If you don’t have a comfortable amount of savings, you want to build that up. If you aren’t putting at least as much into your 401k to get your company match (if applicable), you want to do that before prepaying your mortgage.
      I would really only recommend prepaying any amount, not less any significant amount, if your major financial needs are taken care of and you’re looking for ways to invest. Prepaying is a reasonable way to spread a small amount of your investment money, as it guarantees you a specific return (and I’d argue a larger psychological return). That said, it is essentially “locked” in your house, so it’s not liquid at all. Though in your case it will be liquid in the next 7 years.
      I hope that helps give you some sense of my thought-process with prepaying!
      Thanks,
      Brad

      Reply

  7. People absolutely should NOT pay for a biweekly payment plan. It’s pretty cheesy that many banks charge for this, and if yours does, you can simply add 10% to your payment (ie, $100 for a $1000 payment) and you’ll achieve the same thing. For most people this doesn’t impact the budget too much, but it can save a ton of interest over the life of the loan. Great article!

    Reply

    • Glad you liked the article!! Agreed, you should never get involved in any of those plans, especially if your bank charges you for this “convenience”! As you state, you can absolutely do this yourself by just paying extra principal…

      Reply

  8. I like your column very much. However, I do not understand why people find value in prepaying mortgage principal. Just think how much that $26k that you will have saved will be worth in the year 2043…..a fraction of what it is today. That $100 per month is much more valuable in today’s dollars, whether you spend it save it or whatever. Additionally, your current $954 mortgage payment, a sizable amount in today’s dollars, will be a meaningless small amount come 20 or 25 years from now, so the supposed advantage of knocking off a few years of payments won’t seem nearly as advantageous as it does now. That $1200 per year would be better off stashed in a 529 fund for kids’ college education.

    Reply

    • Joe,
      Thank you for your input — we sincerely appreciate your time and thoughtful comment. From a mathematical perspective you are absolutely correct — prepaying your mortgage is a “bad” idea. I think the psychological benefits of prepaying a small amount each month can potentially outweigh the loss in potential returns though.
      I think this is an issue where people of good faith can argue endlessly and both feel they are “right.” I can certainly see both sides of the argument, and in honesty I do go back and forth, but right now I come down on the side of prepaying a small amount. I really can see how some people think that’s a terrible position, but it is one that I’m comfortable with in my own life.
      Thanks,
      Brad

      Reply

  9. I like the way you describe this. I am not a big proponent of paying off mortgages, but I can see the emotional appeal of doing it. I am allocating my money first to high interest debt, second to tax advantaged retirement accounts, third to low interest debt.
    Heidi

    Reply

    • Hi Heidi,

      Thanks, I’m glad you liked the article!! I like to think there’s ‘real world’ advice and ‘financial guru’ advice, and to me in the real world, many people get a huge psychological boost from seeing their mortgage balance drop considerably every month.

      It’s the same with a tax refund: The financial gurus (and my fellow CPAs) would say that getting a tax refund is incredibly stupid since you could have invested that money over the year instead of letting the government get an interest free loan. But seriously, for that person getting a $2,000 refund who is doing cartwheels because they have all this money, do you really think they would have invested their $40 each week or they would have spent it??

      Reply

  10. I just found this site and I am already loosing sleep over devouring the articles. I like the practical advice that is given out on here as opposed to the guru advice. Some of their methods can be a little silly. Now from a tax advantage point, would it be better to pay the mortgage reaping the tax benefits until the interest principle equalizes? This is where I am currently torn, I’d love to pay off my freshly minted mortgage early, but want to maximize my deductions

    Reply

    • Hi Sue,

      Thank you for such a lovely comment — I really appreciate it! We absolutely try to live our lives in a simple, practical manner, and don’t try to be dogmatic like many of the “gurus” like you mentioned.

      You’d think for a CPA that I’d be all about “maximizing” tax deductions, but I really don’t fall into that camp necessarily.

      From a real financial perspective, over the long run you’ll be better off investing the extra money in a total stock market or S&P 500 index fund instead of paying off your mortgage early. Most mortgage rates are low (4%) and the tax benefit reduces this further. You’ll almost certainly be better off in the long run in the stock market.

      To me there’s a huge psychological component to paying off your mortgage early and you cannot discount that. That’s part of why we prepay a small amount each month.

      The tax benefit from the mortgage deduction is much smaller for most people than they actually realize. The simple reason is that most people are in the 15% marginal bracket (plus state tax) so they are likely only seeing ~20% benefit back. Would you pay $1 in interest expense to get 20 cents back? If you wanted to get into the complicated calculation, I believe the benefit is less than that since most people itemizing deductions aren’t much over the standard deduction level anyway, so the actual benefit of itemizing is small (x 20%).

      Reply

      • I am probably one of those rare folks who bought a house way beneath my maximum mortgage ceiling….mostly because I believe that I should be able to afford my mortgage payment 5 years from now just as easily as I can today, as well all know taxes always go up every year. I am looking forward to year 2 of my taxes since it will give me the best idea about my tax situation. I am not sure for me that itemizing will be more beneficial then just the standard deduction, but I wont know that until I have had a full year of paying taxes and interest. I thankfully have no PMI due to a really awesome mortgage product.

        I am trying to figure out my next move with my federal tax withholding. My filing status allows me to get everything back, but I can’t decide if its worth it to just file like 8 exemptions, 0 exemptions or split the difference all year. I probably should claim the most exemptions and invest the money into something, but i don’t like the idea of getting caught by the short hairs come tax time

        Reply

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