Mortgage Prepayments – Guest Post
Mortgage Prepayments - Tips on Budgeting
Written by: Gary Foreman
I am trying to find the best way to really take advantage in reducing our mortgage to save on interest paid. We are in our home for 5 years with a 30 yr fixed @ 6.1% rate. Payment is $1500 mo. We are now sending in our regular payment weekly by dividing 1500 by 4. On top of that we are sending in $400 to $500 weekly to add to principal. We did not know if dividing the original payment by 4 if it would make a big difference since it is getting there early in weekly amounts. We would sure appreciate advice and help.
TR
Wow! TR is to be congratulated on her dedication to paying off the mortgage quickly. But, let’s see if all those extra payments are reducing the length of her mortgage.
Hopefully, TR has already taken the first step. That’s to make sure that her mortgage allows for prepayments without penalty. Most mortgages do allow it, but it’s good to be certain. If not, they’ll take all her payments and just apply them to the next regular due date. Effectively making all her early payments an interest free loan to her mortgage company!
Let’s talk about what TR is trying to do. By sending one quarter of her monthly payment in each week she could be reducing the amount of interest owed and that would mean that more of her payment goes to reducing principal.
Basically it’s a math problem. We’ll break it down into easy to understand pieces. Beginning with the interest rate.
Typically we talk about interest rates on an annual basis. In this case 6.1% per year. But in reality it’s a daily rate. In this case 6.1% divided by 365 days or 0.0167% or 0.000167 per day.
So the mortgage company multiplies the principal (i.e. the amount that TR still owes on the mortgage) by 0.000167 each day. That amount is added to the amount owed.
Suppose that TR’s mortgage is $100,000 (probably not a realistic number, but a nice round one to work with). For each day TR will owe an additional $16.71 in interest. So for a 30 day month she’d owe $501.37 in interest on the $100,000 mortgage amount.
If her payment were $1500 roughly one third would go to paying the interest owed ($501.37) and two thirds ($1500 – $501.37 = $998.63) would go to reducing the principal.
What happens when TR sends in one quarter of her payment 3 weeks early? The amount she’s sending in is $375 ($1500 / 4 = $375). The amount of interest to borrow $375 for 21 days is $1.32 ($375 * .000167 * 21 days = $1.32). That’s true no matter how big or small the mortgage principal is.
The second weekly payment would save $0.88 ($375 * .000167 * 14 days = $0.88). The third weekly payment would save $0.44 ($375 * .000167 * 7 days = $0.44).
What about the extra principal that TR is sending in weekly? Let’s say that she sends in $500 per week. That $500 is worth $0.58 per week.
So sending in all those weekly payments really isn’t saving TR much money. In fact, if she’s mailing them the cost of the envelope and postage is consuming much of the savings. That, and her time has some value, too.
Now some of you will have noticed that by paying weekly TR has added the equivalent of a full monthly payment each year. But she doesn’t need to make weekly payments to get that effect. All she has to do is to keep adding extra to each payment for principal reduction.
And, in that area TR does have the right idea. By adding $400 or $500 a week to reducing the principal, she’s making a major dent in the length of her mortgage.
Calculating the effects of additional principal prepayments is a little more difficult. The reason is that they reduce the amount of interest owed next month. So the amount of next month’s payment that goes to pay interest is reduced and the amount that goes to pay principal is increased. And, that effects the next month’s payment even more. And, that the month after, etc.
Suppose that TR combines her extra principal into one $2,000 payment per month. She’ll reduce the amount of interest owed by $10.16 ($2000 * .061 / 12 = $10.16). So her next monthly payment will in effect be prepaying an additional $10.16 of principal. And, that will make the payment after that even more effective. Just that one $2,000 prepayment would shorten the life of the mortgage by one and a half years.
Unless you’re a math fiend, it’s easier to use a prepayment calculator you find on the net. One that I like is found here
< http://www.decisionaide.com/mpcalculators/ExtraPaymentsCalculator/ExtraPayments1.asp >.
So what should TR do? Probably skip the weekly payments. They’re having a very minimal effect and increase the chances for a clerical foul-up at the mortgage company. But, TR should continue to make monthly principal prepayments. They’ll make a major difference in the length of her mortgage.
Keep on Stretching those Dollars!
Gary
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Gary Foreman is the editor of The Dollar Stretcher.com website and various e-newsletters including Financial Independence. Financial Independence is designed to walk step-by-step with you as you take control of your finances and achieve financial freedom! For more on mortgage prepayments read: How Mortgage Prepayments Work.
Tagged with: Budgeting tips • personal budget planning • personal budgeting • Web Page Finance
Filed under: Home Finance & Insurance
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Interesting post, thanks for your input. I opted for monthly as opposed to bi-weekly payments for simplicity reasons. I don’t think they offered anything that would have made it financially beneficial to do bi-weekly anyway.
My bank (Trustco) did offer me a lower interest rate by having automatic payment withdrawl though! Pretty good deal to save a bit of cash.
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One of the easiest way to reduce your mortgage debt is to stick with variable rate. Although it has the risk to increase over time it really isn’t on statistics.
Past 25 years variable rate went over fixed rate only 3 times. And those were events like Wars or 9/11. So, my suggestion is to convert to variable rate as soon as your mortgage expires.
I have a home loan and three investment property loans that are variable rate and could not be happier. The investment property loans have been in my name for 25 years.
Bi-weekly payments can be effective, but you will get the same results if you apply more to the principle every month. I am always amazed at how much people can save.
Here is a tip for people that are refinancing and paying off credit card debt. Instead of taking the monthly savings from your refinance and using it on whatever, try taking those savings and reapplying them to your mortgage. You will really watch the interest amount reduce then.
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I know this is a more negative comment but, with the current downwatd trend in house prices, a more sensible option would be to sell up whilst the going is good. Rental values on a decent home are still fairly reasonably priced and, in many cases, you’ll save money by not having to pay additional costs suchs as endowment policies, life insurance, etc.
The equity from the sale can be banked until such a time as you feel ready to jump back into home ownership. With many economists suggesting a ‘correction’ in home values over the course of this year there will no doubt be some great deals to be had.
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Hi GAry,
I once read a book that was saying that if each month we pay the capital portion of the next month, this will reduce a lot the total amount of the mortage. however i dont know if most banks allow to do that. bsicly when we pay our monthly mortgage, this is composed b the capital amount ( which normallyis very litle compared with the interest amount) and the interest amount. So in a total of 1000$ mortgage, maybe you paying 800 interest and only 200 to capital. So as per my understanding, if you pay every month say 1200 ( capital+interst+capital next month) yo will b paying the mortgage mouch quicker and less expensive in the end.
@Ben:
Planning a bi-weekly payment forces us to stay on track with additional mortgage payments. But I believe its not the solution for everyone who wants to quickly reduce their loan principal.
We often recommend to our clients to look into a bi-weekly plan, but to do it themselves, often times banks will offer a plan but their are hidden costs involved or they try and tell you its not a good idea, when in fact its a great idea!
It is certainly commendable to plan to be debt free. For some reason most of us want to use the methods that have been used for generations in spite of the fact that we live in a very different world. There are better ways to accomplish being mortgage free than giving the bank total control over your money. Most will cringe at the thought of doing something different, human nature I suppose to keep doing the same thing that’s been done in the past. that’s what banks count on, it is obviously paying off for them.