Mortgages are often set up in 30 year terms. A mortgage amortization is a schedule of fixed payments, with varying proportions of principal and interest each month. Mortgages are based on simple interest, not compound interest. It is very important to understand how simple interest works in mortgages. Let's say you have a $300,000 mortgage borrowed at 3%. You will pay 3% of $300k or $9,000/12 = $750 in mortgage interest in the first month. Mortgage companies make you pay the entire simple interest due each month and then smooth the reduction of principal over 360 months of 30 years. Making any extra payments towards principal significantly reduces time to payoff a mortgage. Here are some ways to accomplish that goal
- Make bi-weekly payments at half your monthly payment - i.e. if you are paying $2000 a month, start paying $1000 every two weeks in line with your paycheck. Paying bi-weekly does not affect your "monthly" mortgage interest calculation because mortgages are still calculated monthly; however, paying bi-weekly enables one extra payment a year. There are 12 months in a year but 26 two week periods, so you would end up paying $26k (26 x $1000) instead of $24k (12 x $2,000). How much of a difference does that make you ask? A lot! 4yrs and 9 months to be exact, that's how much faster you will pay off your mortgage and only make monthly payments. If you won't notice the change and you are paid bi-weekly, it is well worth the change.
- Another way to accomplish a similar result above is to directly tell your mortgage lender to amortize you loan for 25yrs. Unlike a 15yr loan, you wont see a reduction in your interest rate, but you can expect to pay ~20% less in mortgage interest. That's $120,000 over 25 yrs instead of $150,000 over 30years, a savings of $30,000. In exchange, your monthly payments will see a slight increase of $150 to $2150/month for a yearly total of (2150 x 12) $25,800. That is $200 less than the first scenario $26,000. A direct amortization of 25 yrs has a lower monthly payment vs a 30 yr mortgage paid bi-weekly. The mortgage itself is also shorter at 25 yrs vs 25 yrs and 3 month. It's really a double whammy in your favor, lower payments for shorter!
- Lastly, shortening your mortgage allows you to start with a lower down payment and not wait to own the home of your dreams. If put 10% down and follow an accelerated schedule to pay off your mortgage, you could still pay less in interest over time. The specifics depend on your interest rate and exact schedule of mortgage acceleration, but the principle is that of an intercept and a slope. You can have a smaller intercept and a steeper slope and still cover ground faster.
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