Mortgage

The Effect of Early Loan Payments

Shortly after we bought our first home, I threw together some spreadsheets to examine the amortization of our mortgage. I wanted to experiment how prepayments towards the principal of our loan would affect the total amount of interest we paid to the bank. I learned a couple things that I thought I’d share.

More Interest Upfront

In the early years of a loan, each payment can have more interest than principal. For example, take a $300k loan that is amortized over 30-years with a 4% interest rate. The payment for such a loan is $1,432 dollars. In the first payment, over two thirds of the payment is interest, or $1,000. Only $432 dollars go to reducing the loan’s original principal. It’s not until payment number 152, or 12 years and 8 months into the loan, that the amount of principal finally becomes larger than the interest paid.

Here’s a chart comparing the interest and principal of each payment. The area under red line is the total amount of interest paid over the lifetime of that loan, or $216k:

Shave Off a Month?

Another lesson was learning how much extra I would need to pay to reduce the loan by an additional month. When I posed this question to my children, one of them said “well obviously, you’d need to pay double the size of a normal payment because you’re paying for two months” His answer could be both right or wrong, depending on when that extra amount is paid.

Assume it’s payment number one of the loan example above. To shave off one additional month would take $434.69, saving $998.57 of interest over the life of the loan. Is it coincidence that $434.69 happens to be the exact amount of next month’s principal and $998.56 happens to be the amount of the interest in that second payment?

Fast forward to payment number 153, the crossover point, where the amount of principal in the payment almost equals the interest. At this point we’d need to pay $719 extra to shave off an additional month on the loan, saving only $713 in interest. Again those numbers line up to the amount of principal ($719.21) and interest ($713.04) in payment number 154, the next month’s payment. Again, coincidence?

Nope. It’s not coincidence, it’s math. At any point in your mortgage, if you want to shave off a month’s worth of payment, all you need to do is pay enough to cover the principal of your next month’s payment. Want to shave off two months? Pay enough to cover the principal portion of your next two months.

Conclusion

Paying down one’s mortgage faster is a personal decision. However, if you’re planning on making early payments, you’re better off making them earlier in the life of the mortgage than later.

Any additional thoughts you have about paying down your mortgage early? Leave them in the comments.

Hasta luego!

2 thoughts on “The Effect of Early Loan Payments

  1. We’re 4 years into a 15 year mortgage. I’m not in a hurry to accelerate payments given the 2.875% interest rate.

    Thanks to the 2018 tax reform, I don’t deduct interest any more. Bummer. This gives me a (slightly) bigger incentive to repay now.

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