Impact of Extra Payments on Mortgage Amortization Schedule
When making extra payments on a mortgage, you're not just reducing the outstanding principal. This added payment also helps to reduce the amount of interest that accrues over the remainder of the loan term. Understanding how this works can help you make informed decisions about how to best manage your mortgage payments.
How Extra Payments Work
On an amortized loan, interest continues to accrue on all principal that has not yet been paid. Therefore, if you make a payment above the scheduled amount, it reduces the principal below the scheduled level for that point in the loan term, causing less interest to accrue over the remainder of the loan. If all other payments are made on time, the interest that would have accrued on the principal now being paid early is applied to reduce principal.
Early Prepayment Impact
With a “fully amortized” loan, where there is no balloon payment, the loan payoff date will occur sooner than initially scheduled. If the loan provides for a balloon payment, the amount of the balloon would be less due to the prepayment. It follows that an extra payment will have a much more beneficial impact on the borrower if made near the beginning rather than near the end of the loan term.
Example Scenario
Consider a loan of $100,000 with a 10% interest rate, payable over a 30-year period, with a fully amortized schedule. At the beginning of the loan, your first payment of $877.57 will consist almost entirely of interest, $833.33, with only $44.24 going toward the reduction of the principal. Conversely, your last payment 30 years later will be approximately $870.36 towards the principal and only $7.21 in interest. Clearly, it makes more sense to have that extra payment occur near the beginning rather than at the end of the loan term.
Visualizing the Effect
Imagine a bar graph; the first bar represents the principal balance of the loan at the time of the extra payment. To the right, a second, much larger bar represents the combined principal and interest over the remainder of the loan. At the loan commencement, the left bar would represent $100,000 in principal, while the right bar would be over three times as large, $315,925.77, consisting not only of the principal but also $215,925.77 in interest. This same proportion applies to every extra dollar you might want to pay toward the principal. It reduces the total you have to repay by the same proportion. Therefore, in addition to making the extra payment earlier rather than later, the higher the interest rate, the better off the borrower will be by making a prepayment.
Conclusion
Understanding the mechanics of mortgage payments and amortization schedules can empower you to make better financial decisions regarding your mortgage. By strategically timing extra payments, you can significantly reduce the total cost of your loan and accelerate the payoff date. Whether you're aiming to pay off your mortgage early or simply interested in maximizing the effectiveness of your monthly payments, understanding these principles can provide valuable insights.
Further Reading
To dive deeper into the topic, you might want to explore the following:
Should You Pay Extra Principal on Your Mortgage? Understanding Amortization Schedules Strategies for Paying Off a Mortgage Early