Question: We purchased our home last year with a 30-year fixed rate loan of $250,000. We wanted to get a 15-year loan, but our loan officer explained to us that we could get a 30-year loan and make an extra payment each year toward principal and it would work the same as having a 15-year loan.
The first year, we made one extra payment toward principal and we were told it would eliminate more than two years’ worth of payments. We recently requested our account history from our lender. The report shows the reduction in principal amount, but no reduction in interest payments. How does it work? We just can’t see any benefit, other than reducing our principal.
J.F., Everett
Answer: You’re on the right track. You just have to understand how fixed-rate, amortized loans work. A 30-year fixed rate loan is designed to pay itself off with 360 equal monthly payments. To keep the monthly payments equal, very little principal is paid off in the early years when the interest expense is greatest. As the principal balance gradually decreases year by year, the interest expense also decreases, so a greater percentage of the monthly payment is applied to principal.
By the end of the amortization schedule, the ratio is reversed and almost all of the monthly payment is applied to principal because there is very little interest owed on the small remaining balance. The key to remember is that the payment ratio is heavily weighted toward interest expense for the first two-thirds of the loan term.
For example, if you borrowed $250,000 at 5.5 percent interest on a 30-year fixed amortization schedule, your monthly payments would be $1,419.47. On payment number one, $1,145.83 would be applied to interest, while only $273.64 would be deducted from your principal balance. Ten years into the loan, on payment number 120, you would still be paying $947.94 in interest, with only $471.53 applied to principal. It’s not until you are more than 20 years into the 30-year loan term that the principal portion of the monthly payment finally starts to exceed the portion applied to interest.
Therefore, the best time to pre-pay principal is during the first years of a fixed-rate mortgage. In the example above, you would be paying off about $3,400 worth of principal each year during the first five years of the loan. If you made a lump sum payment of $3,400 toward your principal at the end of the first year, you would effectively jump down the amortization schedule to year 3. That means you would pay off your loan one year early and eliminate 12 payments of $1,419.47, saving more than $17,000.
But the key point to remember is that you only realize that saving amount if you hold the loan for the full term. The immediate interest savings on the $3,400 pre-payment would amount to only about $187 (5.5 percent of $3,400). That’s why the lender’s accounting of your loan showed that your principal balance had been reduced but your total interest expense was almost unchanged.
There are many ways to pay off a fixed-rate loan early:
* You could add an extra $200 principal payment (or any amount you choose) to each monthly mortgage payment.
* You could increase the amount of the extra principal payment each year as your income increased, paying off your loan even faster.
* You could convert your 30-year loan to a shorter term by making your monthly payments based on a shorter amortization schedule. For example, the monthly payments on a $250,000 loan at 5.5 percent interest using a 15-year amortization schedule would be $2,042.71. If you made that payment each month instead of the regular $1,419.47 payment required by your lender under the 30-year amortization schedule, you’d pay off your entire loan balance in only 15 years.
There is no “right” or wrong way to pre-pay the principal on your mortgage. It’s totally up to you.
The bottom line is, keep making those extra principal payments and you’ll own your home free and clear much sooner than if you only pay the minimum required monthly payment.
Just remember that it’s a long-term process. The major savings come in the form of future mortgage payments that you will not have to make. Once your loan is paid, you get to keep the $1,419.47 each month that would otherwise be sent to your mortgage lender. That’s a substantial savings, but you have to be very patient to see the benefits of the prepayment plan many years from now.
Mail your real estate questions to Steve Tytler, The Herald, P.O. Box, Everett, WA 98206. Fax questions to Tytler at 425-339-3435 or e-mail him at economy@ heraldnet.com.
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