Paying Off Your Mortgage

Several months ago, I wrote a post about the pros and cons of paying off your mortgage early. I promised that in a future post, I'd tell you how to do it. Well, here goes.

The best forty dollars I ever spent was to attend a one-day class at a community college near my Seattle home on how to prepay your mortgage. My husband talked me into going.

I had heard people mention "making double payments" to accelerate repaying their mortgages. But our mortgage payment was already over a thousand dollars a month, a big chunk of our income; how could we possibly make double payments?

Early in the life of a mortgage, the bulk of your payment consists of interest. "Double payments" simply means paying two months' worth of principal. When you make a principal payment before it is due, you cut out the interest associated with that payment.

When you purchase a house and secure a mortgage, you should receive an amortization schedule from your lender. If it's not included in the huge packet of papers you receive at closing, ask for one or create your own. An amortization schedule states the amount borrowed, the terms, and the total amount of interest that will be paid by the loan's end date (assuming you stay in the house and make regular payments throughout the life of the loan, without ever refinancing). There will be a breakdown of each month's payment showing how much of the total goes to principal, and how much to interest, as well as the loan balance after each month's payment.

Our teacher ran an amortization schedule for each student in the class, using the loan parameters we provided. We could then use this schedule to track our own prepayments and reconcile with our lender's statement at the end of each year. Now it's easy to create your own amortization schedule online, in Microsoft Excel, or using one of many other readily available computer programs or apps.

For example, let's look at a thirty-year fixed loan for $200,000 with a five-percent interest rate. The payments would be $1073.64 a month, and you would have spent a total of $386,511.57 by the payoff date, assuming you never moved or refinanced. After thirty years, the total interest paid would be $186,511.57, almost as much as the original amount borrowed. Those numbers can be quite intimidating the first time you sign your life away to acquire a mortgage. When my husband and I bought our first home, our interest rate was 10.5 percent on a thirty-year loan, so the figures were even more dramatic.

Here's what an amortization schedule for the thirty-year, five-percent loan for $200,000 with a monthly payment of $1073.64 would look like: 

Payment #	Amount	Interest	Principal	Loan Balance
1	$1073.64	$833.33	$240.31	$199,759.69
2	$1073.64	$832.33	$241.31	$199,518.38
3	$1073.64	$831.33	$242.32	$199,276.06
4	$1073.64	$830.32	$243.33	$199,032.74
5	$1073.64	$829.30	$244.34	$198,788.40
6	$1073.64	$828.28	$245.36	$198,543.04
7	$1073.64	$827.26	$246.38	$198,296.66
8	$1073.64	$826.24	$247.41	$198,049.25
9	$1073.64	$825.21	$248.44	$197,800.81
10	$1073.64	$824.17	$249.47	$197,551.34
11	$1073.64	$823.13	$250.51	$197,300.83
12	$1073.64	$822.09	$251.56	$197,049.27

If you decide to make double payments, you don't need to pay $1073.64 x 2. You simply pay next month's principal along with this month's payment: $1073.64 + 241.31. Now your loan balance has been reduced to $199,518.38 instead of $199,759.69, and you have saved $832.33 in interest. Next month, you will be on payment #3. If you send month #4's principal (243.33) along with it, you'll be on payment #5 by the third month of your loan. Continue these steps and in six months you'll have knocked a full year off your loan payments and saved almost $5000 in interest over the life of the loan. Notice how much faster the loan balance declines; in this example, your balance after six months is the same as it would have been after one year of normal payments:

Payment #	Amount	Interest	Principal	Balance
1	$1314.95	$833.33	$240.31	$199,759.69
		$832.33	$241.31	$199,518.38
2	$1316.97	$831.33	$242.32	$199,276.06
		$830.32	$243.33	$199,032.74
3	$1319.00	$829.30	$244.34	$198,788.40
		$828.28	$245.36	$198,543.04
4	$$1321.05	$827.26	$246.38	$198,296.66
		$826.24	$247.41	$198,049.25
5	$1323.11	$825.21	$248.44	$197,800.81
		$824.17	$249.47	$197,551.34
6	$1325.20	$823.13	$250.51	$197,300.83
		$822.09	$251.56	$197,049.27

Of course, when you use this prepayment method, the principal payments increase a little each month, which could become difficult to manage eventually if your income is not going up. But the beauty of this system is that you are not locked into making the additional principal payment, so if money is tight one month, you can skip or reduce it, or you can stop any time and go back to your regular payment schedule. The initial savings has still been realized.

Think about this option when you first apply for a loan; the sooner you begin prepayments, the more interest you'll save. As you can see from any amortization schedule, the lender collects the bulk of the interest up front, when the loan balance is highest. People who refinance over and over don't reduce their loan balance much over time; most of what they pay is interest, and they perpetually carry a mortgage. ("But it's tax deductible!" they argue.) If you're afraid you might not be able to manage the payments on a fifteen-year loan, take out a thirty-year loan and prepay it, using the double-declining principal strategy to cut your repayment time in half.

You can also customize your amortization schedule to prepay a fixed amount each month, for example, sending your lender an extra $100 toward reducing the principal. Every little bit saves way more interest down the road.

Have you ever thought about pre-paying your mortgage? I'd love to hear your comments.

Sharon Marchisello is the author of Live Cheaply, Be Happy, Grow Wealthy.