What does making extra mortgage payments REALLY do?
Conventional wisdom says that making extra payments towards your mortgage saves interest. Yes … but … is that all that happens? Do you always save more interest than you pay in extra payments? What else happens – maybe even more important to consider?
Here’s an easy calculator online that you may use to see how making extra payments towards your mortgage might work for you. Let’s look at an example using this online calculator to see what really happens.
So … let’s use the calculator in the link above and look at what happens when you pay extra towards your mortgage. For an example, I’ll put inputs as: 30 years remaining, original term 30 years, original mortgage amount $200,000; no extra payments (to establish the baseline so you, the reader, can see differences later on), and annual interest rate 4% (we’ll change this later too – I need numbers so you can see the example).
Now … additional monthly payment input: $100 a month equals $1,200 per year. The calculator says total savings (upper right hand corner) is $26,855 dollars (interest savings). The calculator also says the mortgage period shortened by 4 years and 11 months (59 months). This means that instead of paying 360 payments (12*30) of $955/mo (calculator says I would pay $343,739 total and that I paid extra for a total sum of $316,884 … the difference is the reported savings of $26,855).
However, wait a minute … didn’t I pay an extra $100 per month for 301 months? What does that total? It totals $30,100! I paid $30,100 and saved $26,855 interest! Did I benefit any? Wait to see how at the end.
Let’s do the same for 6% interest … the only number I’m changing is the interest rate. Total savings $49,139. Payment period shorted from 360 months by 5 years and 5 months (65 months) to 295 months. So this time, I paid an extra $29,500 (295*$100) and saved $49,139 interest. Okay … conventional wisdom works with higher interest rates, but not so much when rates are low.
Interest savings matters the higher the interest. What matters most though, is shortening the mortgage repayment period. Why? Because this is a measure that says you are growing equity value in your home faster by reducing the mortgage balance faster. As the mortgage meltdown in the early 2000’s showed, equity (the part you own) matters. The graph on the mortgage calculator in the link shows the difference in mortgage balances.
During the early years of ownership, this is an extra cushion should home values decline a bit again. That extra equity value in your home also means extra reverse mortgage payments later on should you decide to use that route later. Or … should you decide to sell, the extra equity value means extra funds that may generate the income you need. Either way, this means extra money later on in retirement. Even more if the home value grows on top of the mortgage payment acceleration.
Moral of the story: It is not so much about interest savings … it is more about enhancing increased equity value. Not the focus that conventional wisdom had. I suggest changing the focus to what happens to equity … that equity will mean more later should you need extra income either through a reverse mortgage or by selling and downsizing or renting. More equity today also means more cushion should home values go down.
Photo source :By Thugvillage (Own work) [Public domain], via Wikimedia Commons