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Paying Your Mortgage Early

Why pay double? Just pay early.

Today we are going to discuss some of the mathematics behind paying extra towards your mortgage early on.  Here are the assumptions:

  • Mortgage Amount: $150,000
  • Mortgage % Rate: 5% – Fixed
  • Mortgage Term: 30 Years
  • No prepayment penalty

That last one is important.  Few mortgages have prepayment penalties, but always double-check.

Additionally, there are a lot of people who talk about how paying the minimum leverages inflation in your favor, and while this might be true in many instances we are going to ignore this for now as the mathematics are more advanced and few people will sit down and figure it out.

Also, we will skip tax advantages as I’ve rarely seen the “tax advantage” wash the interest.  If you pay your mortgage early, you’ll almost always save more in interest than you would have in taxes.

For a lot of these examples we are going to make use of our mortgage calculator as it is an extremely flexible tool that is available to everyone.

The Pretty Pictures

This is what our mortgage looks like.  The first image shows you by percent of payment (the payment came out to $805.23 each month), and the second shows you in terms of dollars.  Immediately, what you should notice is that you pay a lot more interest in the beginning than you do in the end.

Notice that in the first months, only about 20% of your payment is buying the house.
This image shows you in dollars how little is actually going towards the mortgage in the beginning.

Putting This Information Together

To better illustrate this information, consider your first payment of $805.23 which we’ve modeled below.

This is your first payment.

 Now, what jumps out at you about this payment?  The payment is composed of two parts, your interest cost is $625.00, and the amount that goes to principal is $180.23.  A better way to read this is: it cost you $625.00 to purchase $180.23 worth of your home.

Where else on Earth would you pay that?  Would you borrow $180 from me if, in 1 month, you had to pay me $805.23?  I hope the answer is no.

What Other Option Is There?

Consider the interest your “payment fee.”  In order to buy some of your house, you have to pay this “payment fee.”  The good thing about this “payment fee” is that you only have to pay it once this month, and you can buy as much of your house as you want/can this month without paying it again.  Take advantage of this!

Instead of buying only $180.23 worth of principal this month, why not buy $200, $300, or $400?  No matter how much extra you pay, you won’t have to pay the “payment fee” again this month.  In fact, the more you put in this month, the lower your “payment fee” will be next month!

Next month, your interest will cost you $624.25 and that will buy you $180.98 worth of your house.  Why not buy it this month instead of waiting until next month and having to pay the fee?  For only $625.00 this month you can buy $361.21 worth of your house!  Not bad!

Why Is It Important To Start Early?

If you look at the first graph, you’ll notice that your prinicpal increase, and interest decreases after each month.  What this means is that the extra money you put on your mortgage is more powerful in the very beginning then it is at the end.  The reason is time.

If you put an extra $25.00 on the first payment, then that is $25.00 that won’t accrue interest for the next 30 years.  But if you hold onto that $25.00 and put it on the mortgage 15 years later, then it will have accrued interest for 15 years!

Here is another angle to look at it from: Person A puts $25.00 extra towards their first mortgage payment, but Person B wants to sleep on it for 15 years.  At 5% interest, Person B would need to put $52.84 on their mortgage payment at the 15 year mark in order to receive the same benefit!

Moral Of The Story

Unless you’re a very good investor that can generate yields higher than your mortgage payment, you’re probably better off paying extra on that mortgage.  Just remember, the more you wait to put that extra money down, the more the power and benefit that money will provide declines.

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