Why does it help me to pay off my mortgage faster?

You might have noticed on my mortgage calculator page after you’ve done a calculation that it has a paragraph at the bottom that looks like:

Did You Know…
If you paid just $40 a month more, you would have your mortgage paid off 54 months earlier? You’d save $20,797.14 in interest and your total payments would be $195,735.89.

I sometime get told that the above paragraph doesn’t make any sense (after all, if you owe $100,000, you owe $100,000, right?), so I thought I would explain what is happening.

Let’s start with a simple example. Let’s say that you are buying a home for $125,000 and you are going to be borrowing $100,000 for your mortgage at an annual interest rate of 6 percent. From my calculator above, I see that the monthly mortgage payments would be $599.55. If we look at that in more detail, here’s how it works out:

You start out owing $100,000.

After a month, when you make your first payment, you actually owe the bank $100,000 plus the interest that you’ve accrued on that $100,000 over the past month. For simplicity, we are going to assume that is:

$100,000 + $100,000 * (6% / 12 months) => $100,500.00

$500.00 in interest so far. We know that the monthly payments are $599.55. So, after we make our first payment, we still owe:

$100,500.00 – $599.55 => $99,900.45.

A month passes.

When you make the next payment, you owe the bank $99,900.45 plus the interest that you’ve accrued on that over the past month.

$99,900.45 + $99,900.45 * (6% / 12 months) => $100,399.95

Another $499.50 in interest. $999.50 total interest so far. We know that the monthly payments are still $599.55. So, after we make this payment (we’ve paid $1,199.10 total), we still owe:

$100,399.95 – $599.55 => $99,800.40

After 2 months of payments, we are down to 99,800.40.

Third month, just so you get the idea:

$99,800.40 + $99,800.40 * (6% / 12 months) => $100,299.40
$1,498.50 total interest.
$100,299.40 – $599.55 => $99,699.85
$1,798.65 total paid.

Hopefully this makes sense.

Now.. Let’s say we can come up with an extra $40 a month (skip that steak dinner once a month with your spouse). So, instead of paying $599.55 each month, we’ll pay $639.55.

Let’s start over again from the first month.

The first month’s calculation only changes a little. We still owe $100,500 after interest. But, instead of paying $599.55, we pay that extra $40. After we make our first payment, we still owe:

$100,500.00 – $639.55 => $99,860.45.

A month passes.

You owe the bank $99,860.45 plus the interest that you’ve accrued on that over the past month.

$99,860.45 + $99,860.45 * (6% / 12 months) => $100,359.75

$499.30 in interest. Before, we paid $499.50. We’ve just saved 20 cents in interest. $999.30 total interest so far. After we make this payment, we still owe:

$100,359.75 – $639.55 => $99,720.20

After 2 months of payments, we are down to $99,720.20. We’ve paid $1,279.10 total, and $999.30 in interest.

Let’s do another month just to show more.

Third month, just so you get the idea:

$99,720.20 + $99,720.20 * (6% / 12 months) => $100,218.80
$1,497.90 total interest. That’s 60 cents less interest.
$100,218.80 – $639.55 => $99,799.25
$1,918.65 total paid.

After your second payment, you had saved 20 cents in interest. the next month, you saved 40 cents in interest (in essence, you saved 20 cents for the extra money you paid the first month, and you save another 20 cents for the extra money you paid the second month). This keeps increasing each month! Not only do you get everything paid off sooner, but you actually save interest!

Hopefully this helps explain how paying just a little extra each month can make a big difference at the end of your mortgage. As with most decisions in life, though, there are other details that have to be considered: Some people can’t afford the extra money. There are negative tax consequences to not paying that interest. That extra money could have been invested elsewhere, perhaps making more money than you are saving. I’m not a certified mortgage consultant, but I know people that are! If you would like to discuss these issues, or any other issue about buying or selling a home, please contact me and we can set up a meeting!

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