When it comes to paying your mortgage everyone knows you can save money on the interest by shelling out a little more and applying it to the principal. That means additional principal payments benefit you later on, right? You may also view one dollar today as the same dollar tomorrow. However, that’s not technically true. It depends on how much and why you spend it. If that seems a little confusing, let me break it down a bit more for you. That way you’ll know how much you really are or are not saving.
Let’s look at an example of what I’m trying to say. Here are some assumptions we’ll make. Joe Average secured a $300k mortgage for a 30-year term at 5%. He decided to pay an extra $30 each month to save himself in the long run. In doing so, Mr. Average shaves just over a year, 14 months actually, off his mortgage, thereby saving $13,458 in interest. Not bad.
What if he doubled that $30 to $60? At that point, his home would be paid off just shy of 28 years. This time he’s saved $25,560 in interest. That’s almost double the interest he won’t have to pay now, meaning more money in his pocket later.
Let’s go big though! We’ll say Joe is going to throw $1000 a month extra at it. He is aiming to be debt free and really wants his home paid off. In this scenario, Joe Average saves $170,620 and has the home paid off in 16 years and 11 months instead of the initial term of 30 years.
Here’s what you want to catch. For ever dollar that Joe paid extra, he ended up with diminishing returns. Basically, each dollar gave him less of a return than the previous dollar.
I use this quote by Albert Einstein all the time, “Compound interest is the eighth wonder of the world. He who understands it earns it. He who doesn’t pay it.” It’s especially true in this case. Notice in the table below how doubling the payment does not double the amount saved, nor does it double the time saved in the end. Each additional dollar thrown at the payment is less beneficial than the last.
|Additional Amount||Time Shaved Off||Interest Saved|
|$30||1 yr 2 mos.||$13,458|
|$60||2 yrs 4 mos.||$25,560|
|$150||5 yrs 2 mos.||$55,605|
|$300||8 yrs 8 mos.||$91,742|
|$100||16 yrs 11 mos.||$170,620|
Data via: www.bankrate.com
That isn’t all. Now let’s look at how the when affects Joe. This time Joe Average is only going to throw an extra $100 at his loan. We are still working with a $300k loan for 30 years at 5%.
In the first five years that Joe pays that extra $100, he is saving himself $17,025 in interest and cutting his mortgage down by 14 months. However, if he starts doing so in year 25, he’s only saving $785 and would pay the note off only four months early.
So the same $100 is NOT returning what it was in the first few years of the loan. Here’s a chart in five-year increments showing the impact Joe would make when he applies the extra $100 at different times during the life of the mortgage.
|Years $100 is applied||Time Shaved Off||Interest Saved|
|Years 1-5||1 yr 2 mos.||$17,025|
|Years 5-10||11 mos.||$12,290|
|Years 10-15||8 mos.||$8,304|
|Years 15-20||7 mos.||$5,170|
|Years 20-25||5 mos.||$2,708|
|Years 25-30||4 mos.||$785|
Data via: mtgprofessor.com
So even though we think paying a little more will make a big difference, the reality is that’s not always the case. It depends on when you pay the extra. The sooner you start, the better off you will be. Or you could just invest the money to possibly garner a greater return.