Just about everyone with a mortgage ponders the idea of paying a little extra, whether it’s via scheduled biweekly mortgage payments, or just once a year after receiving a sizable bonus or tax refund.
Whatever the method, you should first consider why you’re thinking about paying your mortgage off early as opposed to putting the money elsewhere.
This is a particularly important question to ask in the super-low mortgage rate environment we’ve been enjoying for some time.
Anyway, assuming you do decide to make larger mortgage payments, whether big or small, your next monthly payment won’t be affected by the previous payment.
You will still owe what you owed the month before, regardless of your principal balance being smaller.
A Mortgage Is an Amortizing Loan with Equal Monthly Payments
- Most mortgages have a set term in which they are paid off in full
- Fully-amortizing payments consist of principal and interest
- With a monthly payment amount that typically doesn’t change
- But the portion that goes to principal/interest will adjust over time
The only thing that changes over time is the composition of your mortgage payment, with the portion going toward principal increasing over time as the loan balance falls.
Extra payments can also change the ratio of principal to interest, which is why they’re so powerful.
Let’s take a look at an example to illustrate:
Mortgage amount: $100,000
Mortgage interest rate: 5%
Loan type: 30-year fixed
Monthly payment: $536.82
In this example, your monthly mortgage payment would be $536.82 per month for 360 months.
The very first payment would apply $416.67 toward interest and the remaining $120.15 would go toward principal.
To calculate the interest portion, simply multiply 5% by $100,000, and divide it by 12 (months). The principal portion is the remainder, as noted above.
For the second payment, you need to use an outstanding balance of $99,879.85 to account for the principal amount paid off via payment one.
So to calculate interest for the second payment, you multiply $99,879.85 by 5% and come up with $416.17. This is the interest due and the remainder of the $536.82 payment is principal.
Over time, the interest portion decreases as the outstanding balance decreases, and the amount that goes toward principal increases.
However, if you make some additional payments, the outstanding balance will drop prematurely.
But instead of your monthly mortgage payments decreasing, the composition of your next payment (and the payment after that) becomes more principal-heavy.
In other words, the payment due would still be $536.82 the next month, but more of it would go toward principal.
And for that reason, less interest would be paid throughout the life of the loan, and the loan would be paid off ahead of schedule. These are the two benefits of making larger payments.
The obvious downside is that you wouldn’t enjoy lower payments in the future, which could be an issue if money becomes unexpectedly tight, especially seeing that you used it to pay your mortgage down quicker.
Recast or Refinance to Lower Future Payments
- Extra payments alone won’t lower future ones
- The only way future mortgage payments will drop
- Is if you recast your loan or refinance it
- Make sure you have money in the bank after making any extra payments
If you make added payments and want subsequent monthly payments to be lower, you have two options.
That’s why it’s recommended to go with a shorter term loan when refinancing such as a 15-year fixed mortgage, which kind of defeats the purpose of lowering monthly payments.
The other option is to request a “loan recast,” where the lender re-amortizes the loan based on the reduced principal balance.
This generally only makes sense if you make a sizable extra payment, something that would really change the payment structure of the loan.
In fact, some banks may only offer a recast it if you make a certain lump sum payment that cuts a certain percentage off the loan. They’ll also charge you a fee to do it.
So while both a refinance and a recast can lower monthly payments, you have to be careful not to tack on more costs as you attempt to pay your mortgage down faster.
At the end of the day, it can be very worthwhile to make larger payments even if your subsequent payments don’t change, just make sure you have money set aside for a rainy day.