Pay More Principal Towards Your Mortgage

What will happen if you pay extra on just the principal balance of your mortgage loan?

1 Answer

If you pay extra towards the principal on your loan, you will end up paying it off faster. Here's why:

The payment schedule for a loan is designed so that if you make a constant payment every month for a given amount of time, the loan will be paid off at the end of the period. This concept is known as amortization. The way it works is that every month, in addition the amount due as interest, the borrower pays a little more. That little extra gets applied to the principal. As time goes by, more of the payment gets applied to principal and more of it gets applied to interest.

If we do a simple interest-only calculation on a $100,000 loan at 8% interest, we find that the interest due per month is $666.67 (100,000 x .08 / 12). Now, if we get out a financial calculator, we find that the monthly payment for a $100,000 loan at 8% is $733.76. So, when you make the first payment on that loan, the lender keeps $666.67 and applies the difference ($66.07) to reduce the $100,000 balance. At the end of the second month, the borrower owes interest not on $100,000, but on $99,932.91. To calculate the payment for that month, we would multiply the interest rate (.08) by that number and divide by 12 again. Since $99,942.91 is less than $100,000, the interest on that figure has to be smaller. As a result, we have more of the $733.76 monthly payment to apply to the principal. As the balance goes down, we owe less and less interest and more and more of the payment goes towards reducing the balance.

So, what happens when you pay extra towards principal is that you accelerate the process. Thus, if you paid an extra $1000 towards principal at the time of your first payment in the example shown above, by the time you had to make the second payment, you would owe interest on $98,942.91 instead of $99,942.41. Since your loan balance is smaller, the interest due on that balance is smaller; hence, more of your scheduled payment goes towards bringing down the balance. If you just paid your regular payment, it would take you until the 15th month of the loan to get the balance down to $98,942. By making that extra $1000 payment in the first month, you end up getting to a zero balance 14 months faster.