This is a guest post from Gary Foreman. Gary is the editor of The Dollar Stretcher.com and various e-newsletters including Financial Independence. Financial Independence is designed to walk step-by-step with you as you take control of your finances and achieve financial freedom! For more on mortgage prepayments read How Mortgage Prepayments Work.
I am trying to find the best way to really take advantage in reducing our mortgage to save on interest paid. We are in our home for 5 years with a 30 yr fixed @ 6.1% rate. Payment is $1500 mo. We are now sending in our regular payment weekly by dividing 1500 by 4. On top of that we are sending in $400 to $500 weekly to add to principal. We did not know if dividing the original payment by 4 if it would make a big difference since it is getting there early in weekly amounts. We would sure appreciate advice and help. – TR
Wow! TR is to be congratulated on her dedication to paying off the mortgage quickly. But, let’s see if all those extra payments are reducing the length of her mortgage.
Hopefully, TR has already taken the first step. That’s to make sure that her mortgage allows for prepayments without penalty. Most mortgages do allow it, but it’s good to be certain. If not, they’ll take all her payments and just apply them to the next regular due date. Effectively making all her early payments an interest free loan to her mortgage company!
Let’s talk about what TR is trying to do. By sending one quarter of her monthly payment in each week she could be reducing the amount of interest owed and that would mean that more of her payment goes to reducing principal.
Basically it’s a math problem. We’ll break it down into easy to understand pieces. Beginning with the interest rate.
Typically we talk about interest rates on an annual basis. In this case 6.1% per year. But in reality it’s a daily rate. In this case 6.1% divided by 365 days or 0.0167% or 0.000167 per day.
So the mortgage company multiplies the principal (i.e. the amount that TR still owes on the mortgage) by 0.000167 each day. That amount is added to the amount owed.
Suppose that TR’s mortgage is $100,000 (probably not a realistic number, but a nice round one to work with). For each day TR will owe an additional $16.71 in interest. So for a 30 day month she’d owe $501.37 in interest on the $100,000 mortgage amount.
If her payment were $1500 roughly one third would go to paying the interest owed ($501.37) and two thirds ($1500 – $501.37 = $998.63) would go to reducing the principal.
What happens when TR sends in one quarter of her payment 3 weeks early? The amount she’s sending in is $375 ($1500 / 4 = $375). The amount of interest to borrow $375 for 21 days is $1.32 ($375 * .000167 * 21 days = $1.32). That’s true no matter how big or small the mortgage principal is.
The second weekly payment would save $0.88 ($375 * .000167 * 14 days = $0.88). The third weekly payment would save $0.44 ($375 * .000167 * 7 days = $0.44).
What about the extra principal that TR is sending in weekly? Let’s say that she sends in $500 per week. That $500 is worth $0.58 per week.
So sending in all those weekly payments really isn’t saving TR much money. In fact, if she’s mailing them the cost of the envelope and postage is consuming much of the savings. That, and her time has some value, too.
Now some of you will have noticed that by paying weekly TR has added the equivalent of a full monthly payment each year. But she doesn’t need to make weekly payments to get that effect. All she has to do is to keep adding extra to each payment for principal reduction.
And, in that area TR does have the right idea. By adding $400 or $500 a week to reducing the principal, she’s making a major dent in the length of her mortgage.
Calculating the effects of additional principal prepayments is a little more difficult. The reason is that they reduce the amount of interest owed next month. So the amount of next month’s payment that goes to pay interest is reduced and the amount that goes to pay principal is increased. And, that effects the next month’s payment even more. And, that the month after, etc.
Suppose that TR combines her extra principal into one $2,000 payment per month. She’ll reduce the amount of interest owed by $10.16 ($2000 * .061 / 12 = $10.16). So her next monthly payment will in effect be prepaying an additional $10.16 of principal. And, that will make the payment after that even more effective. Just that one $2,000 prepayment would shorten the life of the mortgage by one and a half years.
Unless you’re a math fiend, it’s easier to use a prepayment calculator you find on the net. One that I like is found here.
So what should TR do? Probably skip the weekly payments. They’re having a very minimal effect and increase the chances for a clerical foul-up at the mortgage company. But, TR should continue to make monthly principal prepayments. They’ll make a major difference in the length of her mortgage.
Keep on Stretchin’ those Dollars!
Photo by pnwra