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Reducing the time to pay off your loan.
You can save a significant amount of interest on your loan by reducing the time to pay it off. The reason that mortgage loans have long terms (often 25 or 30 years) is to stretch out the cost so as to reduce the monthly payment. However, a main drawback of a long-term loan is that the interest paid over the life of the loan may be some three or more times the amount actually borrowed.
There are a number of types of loans that provide rapid amortization. The easiest to arrange is a 15-year mortgage. This will significantly increase each and every principal and interest (P&I) payment, typically by 20%. A bi-weekly mortgage is another approach. The payment required is one half of a monthly payment for a standard mortgage. This amount is paid every two weeks. Because there are 26 2-week periods in a year, it is similar to making 13 monthly payments in a year. However, such payments will significantly shorten the amortization period, although it may adversely affect affordability, especially if you are stretching the budget to buy the home. It is especially useful, though, for people who are paid every week or every two weeks, but not for those paid monthly or even twice a month (which is not quite the same as every two weeks).
An alternative is to arrange a 30-year loan to keep the payments at an affordable level. Then, you can pay more each month or in a lump sum when you have some extra cash. Keep this important caveat in mind: if you encounter hardship after making extra payments, your lender may not be amenable to reducing or skipping your future payments. You must still pay regularly.
Before prepaying part of a loan, be certain that your lender will cooperate by applying the extra payment to the current principal balance. Some lenders apply prepayments to the escrow account or to the last required payments unfavorable procedures for a borrower. Fortunately, some lenders make it easy to apply advance payments to the principal by providing a space on the coupon book so you can indicate the application of an extra payment. It works like this: the principal and interest (P&J) portion of your payment (don’t count taxes and interest) has been financially engineered to pay off (or amortize, a fancy word for loan reduction) the loan over a certain period, with interest due on the unpaid balance. In a long-term mortgage loan, most of the payments in the early years are for interest, with a small amount for principal reduction (amortization). As the loan is reduced, less of the P&I payment goes for interest and more is used to reduce the debt. Suppose you make an extra payment to reduce the principal. Thereafter, future interest will be less, so more of the payment will reduce the principal, and hasten the reduction of the debt. Any advance payment effectively earns compound interest at the same rate as the mortgage bears, and the advance payment, plus earnings based on it, will shorten the loan term.
Upon making an extra payment, you might want to know exactly how long the new term will be. You can use the following tables to figure this out. However, you will need to know the current principal balance, P&J payment, and loan interest rate.
This article may be published freely as long as you keep the below credits:
Article by (Jack Fredman). For more info on Finance and Refinancing Mortgage loans, visit www.SmartRefinance.net
About the Author: Jack Fredman PhD, CPA, MAI CRE Real Estate Consultant and Appraiser. www.SmartRefinance.net
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