Q: In one of your recent articles, you addressed the point of making one extra mortgage payment a year to reduce the term of a mortgage. Your response states that doing this will reduce the term of a 30-year mortgage by 12 years which is incorrect. It’s closer to 5 years; term will be reduced to around 25 years.
The interest savings over the life of the loan is huge, though.
A: Thanks for that catch. You are generally correct that making an extra payment each year on your loan will reduce the length of the term of your loan between four and six years.
One reason the timeline differs is that the earlier you make a prepayment, the greater your prepayment works for you. But you will also have greater results with a mortgage that carries a higher rate of interest.
I ran some numbers on an online mortgage calculator. Let’s assume you buy a house and take out a 30-year fixed-rate loan at 7 percent for $200,000. Your monthly payment would be $1,330.60. If you made one extra payment per year, you’d pay off the loan in 24 years, saving six years of payments.
But what happens when you get the same loan at 4 percent? Your monthly payment is just $954.83, a savings of nearly $400 per month. But if you make one extra monthly payment, you’d pay off the loan in 26 years, saving only four years of payments.
Why is that? It turns out that the lower the interest rate on the loan, the less effective it is to prepay your mortgage. You’re paying less interest overall (which is good), but you can’t make the numbers work quite the same way.
If your monthly mortgage payment to your lender includes an amount equal to your real estate taxes and insurance, you will accelerate the prepayment of your loan. That’s because instead of making one extra payment, it may be as much as two or more.
For example, if you made an extra annual payment of $1,900 (or roughly twice the regular payment) on the 30-year $200,000 loan at 4 percent, you’d save seven years of payments rather than just four. If you made a $2,700 extra payment (three times the regular payment), you’d pay off your loan in 21 years.
But if you had the same $200,000 loan at 7 percent, and you made a $2,700 extra payment each year (which is just twice the $1,330 monthly payment), you’d also bring down your loan term to 21 years. Again, having a higher interest rate makes prepaying work better.
I should have clarified that point in the prior article. Thanks for your comment.