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How to pay down your mortgage early with an amortization schedule
What is principal?
Mortgage payments have two parts: principal, and interest. For example, if your monthly mortgage is $1000 total, it might be $700 interest and $300 principal. Principal is the money that you originally borrowed from the bank, and interest is what you're paying the bank in exchange for loaning you the money.
Each month, interest accrues based on the balance of the principal. For example, here is a comparison of different payments at the same interest rate:
$1,000 + 3% interest = $1,000 + 30 = $1,030
$900 + 3% interest = $900 + 27 = $927
$800 + 3% interest = $800 + 23 = $823
As you can see, the cost of the interest goes down as the principal balance is lower. What this means is that the lower the balance is, the less you will pay the bank for giving you that loan.
An amortization schedule is a breakdown month by month of what each payment is in principal and interest. Every month will be different. For example, an amortization schedule for a 30-year $100k loan (at 4% interest) will begin like this:
- Month 1 Interest: $333.33, Principal: $144.08, Balance: $99,855.92
- Month 2 Interest: $332.85, Principal: $144.56, Balance $99,711.36
- Month 3 Interest: $332.37, Principal $145.04, Balance $99,566.31
- Month 4 Interest: $331.89, Principal: $145.53, Balance $99,420.88
The pattern that you see is that the interest goes down a little bit every month, and the principal goes up a little every month. Eventually, there will be a tipping point where more of you payment goes towards principal and less towards interest.
There are websites that will generate an amortization schedule, but it's best to get a copy from your mortgage lender to ensure accuracy.
Paying extra towards principal
Most mortgages allow principal payments. What this means is that if you paid your monthly bill (principal + interest), you can put more money directly towards the principal of the balance. If you make principal payments in the amounts shown on you amortization schedule, you can follow along exactly how far ahead you are on your loan.
Look at the amortization schedule below. This would be an example of someone who makes their monthly payment and an extra principal payment every month. You can see that the extra principal payments bypasses the interest that was owed that month. By November 2015, this person would be 5 months ahead on their mortgage!
How to make payments
Contact your mortgage lender to find out how to make extra principal payments. Some lenders have an option to make principal payments through their website. Others may require you to send a check that says "principal only" in the notes.
There's no limits on how many months you pay ahead. The reason this technique works well is that if you have a 30 year loan but make an extra principal payment every month, you essentially have a 15 year loan. While the interest rate on a 30 year loan may be higher than a 15 year loan, you'll have the flexibility to skip extra payments if you ever need to.
It's best to pay ahead on principal early in the loan. As you see in the above examples, the interest is highest at the beginning of the loan, so extra principal payments have a bigger "bang for the buck" than later in the loan.
Why other techniques aren't as effective
There's a couple common techniques for paying down mortgages early. The simplest one is to make extra payments. Another popular technique is to pay your mortgage bi-weekly. The idea is that you're making 26 bi-weekly payments in a year (or 13 months worth), so you're paying extra without noticing much difference.
While there is nothing wrong with these techniques, you're paying ahead on interest that you don't owe yet. By paying on the principal only, you're lowering the balance of your principal which means you'll owe less interest in the long run. If you follow along with your amortization schedule, it's an easy way to see results - you'll be able to see exactly how far ahead you are, how much you are saving, and anticipate when you will pay off your loan.