Do you pay LESS interest when you pay down the principal on your mortgage?

Question

We want to send in a lump sum to put towards the principal on our mortgage...if we do this how does it affect the amount of interest paid. Probably a really dumb question, but is the interest calculated on how much you borrowed initially OR how much you still OWE? Is it worth it to do this?

Answer 1

Just as an alternate opinion: I don't think it's always a good idea to pay down your mortgage debt.

If you have a low interest rate (say, 6%) and you have a decent income, such that your tax deduction for interest paid is about a 30% discount, then your interest would effectively be 4.2%. I'd borrow a billion dollars at 4.2% if a bank would let me, then invest it and make more than that.

Especially if you haven't maxed out your investments in tax-friendly accounts like your 401k or a Roth IRA, I don't think paying extra principle is a good idea (unless you're trying to get to 20% equity, so you can stop paying PMI). I'd rather fill up those contributions first and make 8-10% over the years.

Your investment in your home is "leveraged". If you own 20% of your house and have a loan for 80%, and the price of your house doubles over the years, your initial investment will increase six-fold. But any extra principle you pay off won't see that 6x increase, so there's not much incentive to do so.

Example:

$200k house, $40k down, $160 mortgage at 6%, and both get back a 30% refund on their interest by itemizing their deductions.

Person A pays only interest -- no principle at all -- for 10 years, but invests $150 extra per month in her 401k, and makes 10% on that, plus she invests the 30% refund she gets on her taxes (another $2900 per year)

Person B pays interest, plus $105 per month in principle for 10 years ($105 instead of $150, since she pays with after-tax dollars and 401k contributions are before tax). She also pays down her mortgage with her tax refund (which starts at the same $2900, but decreases as she pays her loan off).

Both are 50 years old now and sell the house when they retire at age 60 for $300k, at which point person A also cashes her 401k and pays 15% tax (lower than the 30% tax she was paying when she was working -- she's retired now).

Person A: $300k - $160k mortgage is $140k, plus an extra accumulated $80k in her 401k, which is worth $68k after taxes. Total: $208,000.

Person B: $300k - $109k mortgage remaining = $191k -- $17,000 less than the person that *didn't* pay down her mortgage.

Note that the sale price of the home actually doesn't matter in the $17,000 difference! The difference is in what they did with the extra $105 -- pay off $105 of 4.2% loan or invest $150 in pre-tax dollars in the 401k. And I didn't even calculate what the diff would have been if the 401k had included a company match!

Taken to an extreme -- would you hurry to pay off a 3% loan? 2%? 1%? No-interest? At some point, it's a good idea to repay as *slowly* as you can -- and I think that mortgage rates of 6%, combined with favorable tax laws for home owners, are at that point.

Doug

Answer 2

Most mortgages calculate their principal and interest by what is called scheduled intereswt. This means that over the life of the loan, interest is scheduled specifically each monthe for the 360 months you have it. What this means to you, is that you cannot affect any change to the interest when a bank or mortgage company uses the scheduled interest model. It makes more money for them. You can pay your mortgage off earlier but there is no true reduction in interest each month.

However, if your bank or mortgage company uses simple interest, then yes, you can dramatically reduce your interest payments and the length of time in debt. For instance, you make a second payment of say five hundred dollars each month on top of normal payment. Only part of your normal payment goes towards principal but the extra payment goes ENTIRELY towards principal. Once the bank has it, thay then recalculate your principal and your interest is adjusted accordingly. That is why a loan that is calculated by simple interest WILL be paid off earlier and with even less money that a scheduled interest loan.

Answer 3

In the long run it will cost less interest. However, you still will be paying interest each month. The best thing to do is to get an amoritization schedule that shows how much you are paying each month. It will give you a break down of what is interest and what is principle for each payment. You will notice that at the beginning of the loan you are paying more for interest and less on principal. But on the last scheduled payment that payment is mostly principal. What I did with my college loan, I made a full month payment and I paid the principal on the last scheduled payment. I had the loan paid off in five years and I saved about $2,500

Answer 4

It is absolutely worth it to do this. The amount of interest paid each month is calculated as follows (this will give you an approximation):

Current amount owed * Interest Rate/12
The rest of your monthly payment will be applied toward the principal. So the less you owe, the less your interest will be, and the more will go towards principal.

Bankrate.com has some great mortgage calculators that will give you amortization tables. You can key in any extra you want to pay, and it will show you how much that will reduce the length of the loan.

Answer 5

If does not make since to do!!

Depending on your age and income bracket paying your home off early is advisable. And how long do you plan to stay in the home? Most people are in a home loan for 3-5 years, which is they only pay interest and minimal principle. I would suggest if you have extra money to pay that you put into some type of investment.
The Federal government did a study on making extra payments, bi-weekly payment and there affects to the home owner, in November of 2006. Bankrate.com is reliable on some information but you are better off to go the horse mouth on this HUD.gov. Also you can check out Businessweek,com and search for the article.
I have been in the financial industry for 5 years and I have told people to put extra cash towards the principle until I did a little more research and found out his stuff.
Cash is king no matter what you do in life. Therefore keep your cash and do not give it to the bank. You will at one point need access to the cash on you may need to miss a payment and you will say",Mr. Banker I have made extra payments can I just miss this one." To which they will reply", No, your payment is due."
There are some books that also talk about how the affluent manage their wealth.

Answer 6

It is absolutely worth it to do this. I don't remember the exact formula that is used to determine how much of your monthly payment is principal, and how much is interest, but with most mortgages, you pay mostly interest at first.

Also, when I got my mortgage, the broker told me that if I made just one extra payment a year towards principal, it would knock 12 years worth of payments off of my 30 year mortgage. 12 years! Anything extra that you can pay towards the principal will save you a bundle in interest. Do it.

Answer 7

ABSOLUTELY it effects the total amount of interest paid. The more you apply yo principal the less interest you pay. This is why it knocks years off your mortgage if you make bi-weekly payments (split you monthly payment in 2)..... just a side note: your interest paid on a mortgage is a tax deduction. Depending on what other debt you have will depend if this is in your financial best interest.

Answer 8

Just a side note to what everyone is saying about paying early payments or extra principle on your monthly mortgage. Make sure IF you do pay an extra payment, or even a little extra on each payment that you mark it as "apply additional payment to principle". My friend Jessica was rounding her $816 mortgage up to $900 each month. Instead of applying the extra to her premium, the issued her a check at the end of the year which stated "over-payment". I saw the check along with the letter stating that if she wanted the money applied to principle, the check needed to state this! Good luck!

Answer 9

Your monthly payments pay off all the interest due that period and any left over is taken off the principal. You interest is calculated based on the balance owing. So unless there is a penalty clause it is worth paying off as much as you can afford. But always pay off higher interest loans such as credit cards first. http://www.fool.co.uk

Answer 10

On how much you still owe. Generally it's a good idea UNLESS you can earn a GREATER rate somewhere else than you are paying on the mortgage, which is unlikely.