Tuesday, May 18, 2021
Like many of us, Tanya would like to get the mortgage paid off in something less than 30 years. And, she's willing to pay a little more than promised to accomplish that goal. So let's see whether one extra payment a year is enough to get the job done.
Tanya does have the right idea. Especially in the early years of a mortgage. Her monthly checks repay very little of the principal at first. It will be years before she's made much of a dent in the amount owed on the mortgage.
Let's take a standard 30 year, 8% mortgage. At the end of the first year, Tanya will still owe $991.65 for every $1,000 she borrowed. She will have written checks for $88.08 and only reduced the principal by $8.35. So for the first year for every dollar that she paid, less than one thin dime went to repay the amount she owed.
So Tanya's strategy is a good one. Put more of each payment to work reducing principal because there's less interest owed.
But unfortunately she won't be able to cut her mortgage term in half with one extra payment per year. At least not at today's interest rates. In fact rates would have to be 17% for that to happen. But that doesn't mean that it's still not a valuable tool for Tanya to consider.
One extra payment per year on an 8% mortgage would move her payoff on a 30 year mortgage up seven years. Not a shabby reduction.
An alternative would be to add 1/12th of a payment to each monthly check. That would spread out the extra payment over the year. Doing that would pay off the mortgage a couple of months sooner than the extra annual payment.
So one extra payment wouldn't cut the mortgage in half, but it would cut about 25% off of the term.
What about other debts? The idea is the same. Paying additional principal means that more of each future payment is reducing even more debt rather than just paying the interest owed.
One major difference. The longer the life of the loan the bigger the effect of any prepayments. Paying extra principal on a 30 year mortgage makes a big difference. The difference on a 3 or 4 year auto loan isn't so significant.
For comparison, we're going to assume an 8% 48 month car loan. For every $1,000 borrowed the monthly payment would be $24.41. The payment is higher than for the mortgage because the $1,000 that was borrowed is being repaid over a much shorter period of time.
For instance, in the first month that $24.41 payment actually reduces the amount owed by $17.75. But adding one extra payment per year will only pay off the loan 3 months early. So paying extra principal on an auto loan won't make a huge difference.
But that doesn't mean that the strategy only works for mortgages. Credit card debts are another fine candidate for extra payments. Most credit cards are designed to keep you in debt forever.
Many payments are as low as 1.5% of the amount owed. That means that you'll be paying only $15 per $1,000 owed. And if your interest rate is 15% (a typical rate) you'll be paying off that debt for 133 months or over 11 years. Even if you don't charge another cent or trigger any fees on the account.
Doubling the $15 minimum payment to $30 would cause the loan to be repaid in just 43 months. A big difference.
So Tanya's on the right track. Paying extra can make a difference. To get the biggest bang for her buck she should use extra money to pay off loans that run for many years like mortgages. Or ones that carry a high rate of interest like credit cards.
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