It can be so easy to make the minimum payments on debt. But it’s really worth fighting this with large debts because of the way interest compounds. For example, making one extra payment per year on your home loan — paying off mortgage early — could save you over $55,000 on a 30-year fixed mortgage for a $200,000 home.
The Impact of One Extra Payment Per Year
Let’s take a look at the math to see how you can save over 25% of the value of your home with a single extra payment per year.
Let’s say you have a $200,000 mortgage with a 30-year fixed-rate of 6.5%. (That’s a little high for the current market, but if you bought your house before the recession, you might be wishing you had that mortgage.) At that rate, your monthly payments would cost you $1,264.
Making a single extra payment per year (of $1,264) and that could save you $55,990 and 6 years of payments!
This is because that extra payment is going entirely toward your principal. Here’s an illustration we’ve selected from a larger infographic from HomeInsurance.org, which displays this exact hypothetical visually.
Click to view the whole infographic at HomeInsurance.org
Paying Off Mortgage Early: A Quick Breakdown
I’ve already explained amortization formulas in a previous post, so you can learn all about the way these kind of debt calculations break down.
But for the sake of understanding this specific hypothetical, let’s take a look at how much of a typical payment goes toward interest, and how much goes toward principal.
To do this, you first need to understand this fact: As you make more payments, a larger and larger portion of each payment goes toward principal, reducing your debt faster and faster.
Here’s the formula for figuring out how much of your monthly payment is interest:
Monthly Interest Payment = Principal Balance x Monthly Interest Rate
On the first payment, $200,000 is the principal balance and .54% is the annual 6.5% interest rate divided by 12 months.
$200,000 X .54% = $1,080 in interest. That means only $184 of your first mortgage payment goes toward your balance.
By the time the remaining principal balance is $100,000, just $540 of your total payment would be interest, leaving $724 to go toward principal. Much better.
This makes it easy to see why making an additional payment of $1,264 in that first year is huge for paying off mortgage early!
To learn more about how mortgage loans work, check out this post titled What Does APR Mean?
Paying off mortgage early? How are you doing it? Let us know your strategy below.
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