mortgage interest

Start Taking an Interest in Interest: Mortgages

First up is mortgages, the type of loan where you’ll pay the most interest. With a mortgage, people often make the mistake of thinking that their payment is going mostly to the principal.

WRONG!

Especially in the beginning, a significant portion of your payments go toward the interest, not the principal!

You may not know this, but with a standard mortgage the interest is calculated monthly. The amount of interest versus principal you pay with each monthly payment can be easily calculated through an amortization schedule calculator. While these tools are readily available on the internet (just Google amortization schedule calculator) and often offered by lenders, not many people actually do one. We also designed our own interactive amortization schedule calculator, which you can download for free below by clicking the link.

 

Download our interactive amortization schedule calculator to see how much interest you could save on your mortgage!

 

The numbers are staggering.

Let’s say you just bought a house. You have good credit and little debt, so you landed a 30-year mortgage with a fixed interest rate of 4% (about the national average). To makes things simple, let’s say you put 20% down and have a conventional loan (a 20% down payment eliminates mortgage insurance, which will add even more to the monthly payment). The balance of your mortgage is $200,000, your yearly home insurance is $500, and your taxes are $3,000. You just made your first payment of $1246.50 (PITI). If you take out taxes and insurance, the payment going toward the loan and interest is $954.83 (PI).

Want to know where your money is going?

You just made your first mortgage payment, and a whopping $666.67 (or 69.8%!) went to…

You guessed it, JUST INTEREST!

Your first payment (PI) will show $288.16 toward the principal, and $666.67 to interest (don’t forget you also have to pay taxes and insurance).

And it doesn’t get any better any time soon.

Take a look at this amortization schedule for the hypothetical mortgage we were discussing above.

The table above is only a partial schedule, which includes the first and last year, as well as a few key months in between. Highlighted in yellow is the month that your payment is ALMOST split evenly between the principal and interest. This is a milestone that comes 12 years and 8 months into your loan!

Then, you’ll notice that the first month where most of your payment (but not much more) goes toward the principal is month 153 (highlighted in green), or 12 years and 9 months into the mortgage!

I repeat.

FOR ALMOST 13 YEARS THE LENDER IS TAKING MOST OF YOUR PAYMENT FOR INTEREST!!!

If the fact that most of your monthly payment is headed toward interest for almost half of the life of the loan isn’t enough, how about the actual amount of interest paid over the total life of the loan?

Sit down and hold onto something. Seriously.

If you only stick to your mortgage payment every month for 30 years, you will have paid back a $200,000 loan along with…an additional $143,739 in interest!

The total cost of your home over 30 years?

$343,739!!!

It’s okay, take a few deep breaths.

I promise buying a home is still totally worth it (remember a home is something that typically appreciates), but it is probably the most expensive investment you will make in your life due to the interest you’ll pay. But it doesn’t have to be quite so bad.

Don’t believe me?

Remember, Money Saved is Money Earned, and we know just the way to save big interest on your mortgage payment by letting you in on a big secret.

Here’s the deal.

Think of it this way. You really have two loans you’re paying with a mortgage: the principal balance (principal loan) and the interest (interest loan). The principal is a fixed amount, but the interest you’ll pay can be variable, depending on you.

Here’s how you can reduce your interest loan.

Every regular monthly payment is paid to both the principal and interest loans, but anything above and beyond the regular monthly payment is paid to the principal loan only. This means an extra payment of any amount will lower your principal, thus lowering the amount that interest is calculated on. Lowering your principal balance lowers the amount of total interest you pay and the total amount you’ll pay for the home.

Want to know something else? The faster you pay the principal loan amount down, the more interest you’ll save (less balance means less calculated interest). This means that a larger amount of interest will be saved by making extra principal payments at the beginning of the loan when the balance is higher. Now we know it’s difficult to make extra payments right after you buy a house (there are A LOT of unforeseen expenses, believe us!), but if you’re able, making extra payments in the first 5 years of the loan will give you the biggest savings in interest.

Let’s look at a few examples.

First, let’s look at the power of making an extra payment at the beginning of the loan. Let’s say you pay a double payment the first month. Using the example above, you would pay your mortgage payment of $1246.50 plus an additional $1246.50 toward the principal. If that was the only extra payment you made over the 30-year life of the loan, you would end up paying $140,891.78 in interest. The total cost of your home is now $340,891.78 (compared to $343.739).

That one extra payment saved you $2,847.22 in interest! ONE PAYMENT!

Still not convinced?

Let’s look at something more substantial. Let’s say you make an extra mortgage payment every year. That’s an extra $1246.50 going toward the principal every year. Over the life of the loan, making an extra mortgage payment every year would result in you paying $115,077.36 in interest. Now, the total cost of the home is only $315,077.36 (compared to $343,739 when paying off the loan as scheduled).

These extra payments have now saved you $28,661.64 in interest!!!

Not only that, making extra payments reduces the life of the loan. With the scenario we just described, you would not only save almost $30K in interest, but you’d pay off your mortgage after only 24 years and 10 months!

Another option is to start making extra payments every month in a smaller amount, such as $100 or $200. This will result in even more interest savings and reduce the loan term faster. In this scenario, every month your principle balance is going down, which results in savings in interest on a monthly basis.

The scenario we described may seem like a lot of money, but tightening your belt and making 25 extra payments (1 per year) of $1246.50 (totaling $31,162.50) toward the principal saves you almost $30,000 in the end.

What could you do with an extra $30K?

Talk about Money Saved!

 

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5 thoughts on “Start Taking an Interest in Interest: Mortgages”

  1. Mr. MFC @ Morning Fresh Cent

    This is why many mortgage love the 30 year as opposed to the 15 years or shorter loan. These banks make a ton of money from interest. Making additional payment is good, just be sure it is going towards the principal directly. Some mortgage if you don’t specifically specify for principal, then they apply that additional amount to the next month’s mortgage portion instead.

  2. Joel and Emily - Beyond a Budget

    Great explanation on something a lot of people don’t understand! Thanks for sharing!

  3. Those are some staggering numbers there. Our biggest mistake was buying a McMansion but now it is our home and we are going to pay that thing off. I figure I can do it in 8 years without sacrificing 401k and IRA contributions.

    1. A McMansion! That’s so funny! Whether a McMansion or not, that’s amazing that you’ll be able to pay it off in 8 years. You’ll save so much in interest and then be able to use that money for other things.

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