Understanding Principal Versus Interest
For each mortgage payment you make, the money is first used to pay the interest on your mortgage loan. The remaining portion of your payment is then used to reduce the principal, which is the amount that you borrowed from the lender.
In the first years of the mortgage, most of the payment normally goes toward the interest costs.As a result, the principal, or the amount that you owe, may decrease by only a small amount. As the mortgage balance decreases over time, more of each payment goes toward paying off the principal.
The key to saving money on your mortgage is to pay off the principal as fast as possible.
If your household budget allows you to reduce the time you need to pay your mortgage in full, you could save thousands, or even tens of thousands of dollars in interest charges.
Ways to pay off your mortgage faster
1. Increase the amount of your payments
One of the ways to pay off your mortgage faster is to increase the amount of your regular payments. Normally, once you increase your payments, you will not be allowed to lower your payments until the end of the term. Check your mortgage agreement or contact your mortgage lender for your payment options.
• John is getting a mortgage of $150,000, amortized over 25 years, with a fixed interest rate
of 5.45% for 5 years.
• The mortgage lender tells him that that he must pay at least $911 a month.
• He is trying to decide if paying $50 more a month will help him save money.
2. If you renew with a lower rate, keep the monthly payments the same.
At the end of your mortgage term, when you renew or renegotiate your mortgage, you may be able to obtain a lower interest rate. Although you would have the option of reducing the amount of your regular payments, you can take advantage of this situation to pay off your mortgage faster. Simply keeping the amount of your payments the same will make you mortgage-free sooner.
• Stefanie used to pay $1,000 each month on a $150,000 mortgage.
• When she renewed her mortgage after five years, the interest rate had decreased by one percent, from 6.45% to 5.45%.
• While the lower interest rate would have reduced Stefanie’s monthly payments to $924, Stefanie decided to keep the monthly payment at $1,000 in order to reduce the total amount of interest she will pay over the term of the mortgage.
• Stefanie is renewing her mortgage after five years for another five-year term.
• The remaining mortgage principal amount is $135,593.
3. Choose an “accelerated” option for your mortgage payment.
You can spend approximately the same amount of money on your mortgage each month and still save money by choosing an accelerated option for making your payments.
Most financial institutions offer a number of payment frequency options:
Accelerated Payment Options:
Accelerated weekly and accelerated biweekly payments can save you thousands, or even tens of thousands in interest charges, because you’ll pay off your mortgage much faster using these options. The reason is that you make the equivalent of one extra monthly payment per year.
Standard Payment Options:
For these four payment options, there is no difference in the total amount you will pay over a year. This means that there is very little extra savings if you switch from a monthly payment option to one of the other standard payment options.
Example: Impact of changing the payment frequency.
The table below shows the payment frequency options offered to John by his lender, their
impact on his mortgage payments and how much he can save over the amortization period.
• Mortgage principal of $150,000 amortized over 25 years
• Interest rate of 6.45% for the entire amortization period
4. Making lump-sum payments: Prepayments
A prepayment is a lump-sum payment that you make, in addition to your regular mortgage payments, before the end of your mortgage term. The prepayment reduces your outstanding balance and allows you to pay off your mortgage faster.
The sooner you can make the prepayment, the less interest you will pay over the long term, and the sooner you will be mortgage-free.
Key things to remember
• Your mortgage agreement will specify whether you can make prepayments, when you can do so and other related terms or conditions. Read it carefully, and ask your mortgage lender to explain anything you don’t understand.
• If your mortgage lender is a federally regulated financial institution such as a bank, as of January 2010, it must show your prepayment options in an information box at the beginning of your mortgage agreement.
• Your mortgage agreement may specify minimum and maximum amounts that you can prepay each year without paying a fee or penalty.
• The prepayment option is generally not cumulative. In other words, if you did not make a prepayment on your mortgage this year, you will not be able to double your prepayment next year.
• A closed mortgage agreement may require you to pay a penalty or fee for any prepayment.
Questions to ask
When shopping for a mortgage, make sure that you understand the prepayment options and conditions before you sign the contract. Ask the lender the following questions:
• How much can I prepay without paying a fee or penalty?
• Is there a minimum amount for a prepayment?
• When can I make prepayments?
• Are there any conditions?
• If there are fees or penalties, how much are they, and how are they calculated?
• John received a raise which allowed him to save $15,000.
• He decides to use it to make a prepayment on his mortgage at the beginning of the second year of his term.
• However, his mortgage lender limits prepayments to a maximum of 10% of the principal.
• John wants to know whether he can make that large a prepayment, and if so, how much sooner he will be able to pay off his mortgage as a result.
• Mortgage of $150,000, amortized over 25 years
• Lump-sum payment limit: 10% of principal allowed once a year
Original mortgage: $150,000
Limit allowed by John’s mortgage lender: x 10%
Allowed lump sum payment: = $15,000
John will be able to use his raise to make a $15,000 in lump-sum payment, since he is allowed to prepay up to $15,000 each year.
You can save thousands of dollars in interest by paying off your mortgage as fast as your household budget allows. These four ways will help you to achieve the goal of being mortgage-free sooner:
• increasing the amount of your payments
• keeping your payments the same amount if you renew or renegotiate your mortgage with a
lower interest rate
• choosing an accelerated payment schedule
• making lump-sum prepayments.
With your mortgage paid off, a big part of your household budget will be available to help you to achieve your other financial goals.