Q: I read your column regularly and it is very helpful and informative.
My question is in regards to paying extra on the principal of one’s mortgage.
I realize that prepaying on the loan, whether it is just a little or the equivalent of one additional payment per year, is a good thing. Also, thanks to your column I am aware that I can reduce a 30-year loan to 21 years by making that extra payment each year.
I took out a 10-year loan in August, 2003. The loan will be paid off in July 2013. I made an additional payment last year with the idea of shortening my loan. Can you tell me how much this will shorten my loan and whether this is even worth doing on such a short loan? Making our monthly payment is not a problem.
A: Because you are paying off your loan in 10 years, instead of 30, you’ve already cut the amount of interest you’ll pay over the life of the loan. And because you’re already more than 4 years into your loan, prepaying at this point will offer you little benefit. It will shorten the term of your loan a tad, however.
If you were starting to pay off a 10-year mortgage today, one extra payment per year would only slash a year off of your loan. Two extra payments would slash your 10 year loan to about 8.5 years.
How much will you save overall? Assuming you took out a $100,000 loan at 5 percent, you’d pay about $28,000 in interest over the 10 years of the loan term. If you make two extra payments per year, you’ll pay just over $22,000 in interest, a savings of $6,000.
The reason you don’t save any more than that is that the big savings comes when you’re able to cut more years off of the loan. For example, if you have a 30-year loan at 6.5 percent, and you make an extra payment each year, you’ll pay off your loan in 25 years, and save $28,000 in interest. If you double your payments, you’ll pay off the loan in 9 years, and save nearly $97,000 in interest.
But at only 10 years, you’re not borrowing that much money for very long. So, pre-paying doesn’t give you the same savings as on a longer loan term.
To play around with the numbers, go to the tools section at Eloan.com. Look for mortgage calculators and click on the amortization calculator.