Understanding Early Mortgage Payments

If you are considering reducing your mortgage term by making extra payments, understanding how early payments work can help you make informed decisions. Early payments can help you to save money on interest and get out of debt faster, but they must be managed correctly to ensure they go towards reducing your principal balance.

Can You Make Early Mortgage Payments?

It is important to remember that not all mortgages allow early payments without penalties. You should check your mortgage documents to ensure that early payments are permitted. Failing to do so could result in payment penalties or other fees. Most mortgage agreements do permit early payments, meaning you can prepay your mortgage by making additional payments to your principal at any time, without penalty.

How Do You Make Early Mortgage Payments?

One of the easiest ways to make early payments is by depositing the extra amount directly into your loan account. You can specify on the payment slip that the extra amount is for paying down the principal, or better yet, call your lender and add the additional amount to your current monthly payment. By reducing the balance of your loan, you not only save money on interest but also decrease the duration of your mortgage term.

Understanding the Components of a Mortgage Payment

A typical mortgage payment consists of three or four components:

Principal: This is the loan amount that you borrow and the amount that you need to pay back. The principal amount is typically low at the beginning of the loan but increases slightly with each payment over the life of the loan. Interest: Interest is the cost of borrowing money and it is typically high at the start of the loan and decreases slightly with each payment over the life of the loan. Escrow: This is usually the sum of things like home insurance, property taxes, and HOA fees. The amount can vary from year to year and typically increases as property taxes go up. PMI: This is for primary mortgage insurance, which is usually added to loans where less than 20% of the purchase price is used as a down payment.

It's worth noting that the sum of the principal and interest components is a constant. This sum will never change over the life of the loan for a fixed-rate loan. In a variable-rate loan, this sum is constant until each time the rate changes. The distribution of the principal and interest components changes over time, which is the time value of money.

How Extra Payments Affect Your Mortgage

When you make a payment, the principal component is subtracted from the amount you owe, while the interest component is paid to the bank as interest income. By making extra payments, you pay down the principal balance of your loan earlier than expected, which in turn reduces the amount of interest you pay in the future.

The amortization schedule shows the distribution of the principal and interest components over time. For a mortgage, this schedule is typically 30 years or 360 monthly payments. As you make payments, the amount owed goes down, and with each payment made, the interest payment for the next payment decreases. When no money is owed, the interest component becomes zero.

The act of paying off your mortgage early means you are making extra payments to the principal balance earlier than expected on the amortization schedule. This reduces the total interest paid over the life of the loan. For example, if you make one extra payment a year, you could reduce a 30-year mortgage to around 22.5 years. Some people add a little extra each month, while others might make two extra payments each year. Higher interest rates mean a higher incentive to make extra payments as the interest savings will be greater.

Conclusion

Early mortgage payments can be a powerful tool for reducing the duration of your mortgage and saving money on interest. However, it is essential to check your mortgage documents to ensure early payments are permitted and to manage your payments correctly to ensure they go towards the principal balance. Early payments can significantly benefit those seeking to reduce their debt and achieve homeownership faster.