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Why pay extra toward mortgage principal?

Dr. Don Taylor, Ph.D., CFA, CFP, CASL
Don Taylor

Dear Dr. Don,
My question deals with the wisdom of paying your mortgage principal early. If you have a fixed-rate mortgage, with its associated amortization schedule, can't you achieve a significantly higher "return" by making additional principal payments at the top end of the amortization schedule? For example, say your mortgage payment is $1,000, comprised of $100 toward the principal and $900 in interest. If you paid that $1,000, and then added another $100 toward next month's principal, wouldn't you save the $900 interest for next month?

-- Wendell Winnow

Dear Wendell,
There are many reasons why people pay off a mortgage early. They may want to be debt-free, for example. They may want the house paid off before retirement.

From a strictly financial point of view, you will want to pay down or pay off the mortgage if you expect the after-tax returns on your investments to be less than the effective rate on your mortgage. The effective rate includes any realized tax benefits from the mortgage interest deduction. A mortgage with a stated rate of 4.5 percent might have an effective rate in the mid threes depending on your tax bracket and your ability to fully utilize the deduction.

Now, to your question: I'm not sure if you've thought that plan through. Your interest payments are based on your outstanding loan balance, not on your monthly principal payment. If you pay next month's principal payment, you will save a little interest, but not that much because your overall balance hasn't been reduced by that much.

If the mortgage interest rate is 4.5 percent, a month's worth of interest on a $100 prepayment of principal is 37.5 cents. No pot of gold at the end of that rainbow.

However, if you keep making additional principal payments every month, you can significantly reduce your interest payments over time. For example, if you pay an additional $100 to your principal every month, it'll reduce the interest and loan term as shown below.

Pay down my mortgage?

New mortgage New mortgage with additional principal payments Difference
Loan amount $100,000.00 $100,000.00
Interest rate 4.5% 4.5%
Loan term (months) 360 258 -102
Loan payment $506.69 $506.69
Additional principal payment $- $100.00
Total monthly mortgage payment $506.69 $606.69 + $100.00
Total interest expense $82,406.71 $56,028.95 -$26,377.76

The mortgage magic in prepaying your mortgage isn't in reducing intramonth interest expense. It comes from paying down your outstanding loan balance with additional principal payments.

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