We know from my last post on mortgages, that a significant portion of a mortage payment goes towards interest in the beginning of a mortgage. With each subsequent mortgage payment, a smaller portion goes to pay interest and a larger portion goes to pay principal. This chart illustrates what the process looks like:
The blue line represents the interest portion of the payment. Notice how it starts nearly at the $1,200 line. The pink line represents the principal portion of the payment, which begins really small. Now notice how the two lines meet at around payment number 242. In fact, payment number 242 is the FIRST payment where amount towards principal is GREATER than the amount going towards interest. Amazing, isn’t it? It takes over 20 years worth of payments BEFORE you are paying more towards the house than you are towards interest.
This is all a function of interest rates. The size of the mortgage doesn’t matter. As you would probably guess, the greater the interest rate, the longer it takes to “break even” on your payment. I put together a little chart that shows the payment number of the first payment in which more of the payment was applied to principal than interest:
Int |
Payment |
Percentage |
4% |
153 |
42.5% |
4.5% |
176 |
48.9% |
5% |
195 |
54.2% |
5.5% |
210 |
58.3% |
6% |
223 |
61.9% |
6.5% |
233 |
64.7% |
7% |
242 |
67.2% |
7.5% |
250 |
69.4% |
8% |
257 |
71.4% |
8.5% |
263 |
73.1% |
9% |
269 |
74.7% |
9.5% |
274 |
76.1% |
10% |
278 |
77.2% |
The last column shows the percentage of the mortgage payments where the interest portion was greater than the principal portion. It is amazing to think that over a 30-year loan that 15 – 20 of those years are spent paying more in interest than in principal. Wow! I’ll never look at my mortgage payment the same!
Cant you put a clause in the contract having payments going to the principal? eeehhh?
Ryan, you would have to send in extra money to apply towards the principal. If you were allowed to pay only towards principal, interest would compound, and accumulate.
Thanks for the analsysis! All this tells me is to add on some money every month to my mortgage payments so I can save interest over the duration of the loan.
I am 7 1/2 years into a 30 year mortgage at 6.5% and by aggressively making extra payments, I hit the break point (50% to principal with each regular payment) at 88 months rather than 233 months. I found the chart VERY reenforcing to my efforts to retire this debt in under 10 years. Thanks for the encouragement.
If you can invest the money at better than the rate you pay on your mortgage it makes no sense to make extra payments. With today’s rates, even a relatively conservative protfolio can do better than most existing mortgage rates, especially when you consider the tax savings.
You can look to get into a mortgage with an Equity Builder. A loan with such can cut into the loan faster because it is basically accelerated. The interest rate may be higher, but the difference in interest rate is negated by the extra payment going directly to principal. You can do this by paying a normal monthly payment instead of extra $$$ that can otherwise go into a savings/retirement vehicle.
I think the right hand column in the last row (10% interest) is a typo. Isn’t it? How could the percentage of payments drop so dramatically when the rate goes up?
Nickel,
Yeah, you’re right. I skipped a number and that threw everything off. Thanks.
Wow, that’s crazy. Two thirds of the way through before you’re paying yourself more than you’re paying the bank.
I’m SO GLAD I stretched a bit and got a 20 year loan instead of 30. And I also prepaid $1000 in the first year, so hopefully my chart looks a little better than the one above. I know, I know, I should have put that $1000 in a retirement account. But the psychology of money is such that sometimes you don’t do the smartest thing.
One definitely saves interest by prepaying. However, the part I am confused about is that is it better to prepay / invest?
Or in other words: Do the lost tax benefits and lost opportunity costs (by prepaying) counterbalance the saved interest?
thanks
From the land of mortgage brokering, yes pre-paying or doubling payments does save you both in time and interest paying out the mortgage.
Beware however, the limit to prepaying is usually spelled out in your mortgage contract. Most lenders I deal with limit the pre-payment to 20% (in case anyone wins the lottery).
As to the comment, is it better to prepay or invest? That depends on what you are able to earn with the money you planned to prepay. Will you get greater than the current posted rates at the bank? Yes, invest it. You are a head of the game.
From an investors point of view, invest it in a rental property and have the tenants pay for the mortgage. This is termed “good” debt. Leveraging the banks money, have someone else pay for it and you end up with the asset at the end of the term (and potentially retire off this net income).
I like to see 4 points for a mortgage:
1) “Half-way” point – where you’re paying more toward the principle than you are toward interest with every mortgage payment.
2) Total Principle paid versus Total Interest paid
3) Total Principle is half of what was originally borrowed
4) Term (when the loan is paid off of course)
Our 15 year @ 5.5% shows the following (as someone else mentioned, the amount borrowed is irrelevant):
1) 30th payment (2 1/2 years)
2) 57th payment (4 3/4 years)
3) 109th payment (9 years 1 month)
4) 180th payment (15 years)
John W.:
I can’t imagine having something spelled out in the mortgage that stated you were limited in the amount you could pre-pay. I asked our loan officer (and of course double-checked the mortgage itself), and there is no such pre-payment limitation.
Claire:
I wrote a small application that handles amortization scheduled and pre-payments, and adjustable rates, on top of a few other financial calculations. I still need to do some work on the graph though. But, if you want, I could e-mail it to you, just send an email to me: “cc_mynews at comcast dot net” (of course you’ll need to change the “at” to “@”, and “dot” to “.”)
How can one directly calculate the crossover point when the amount of each monthly payment that goes toward the principal is approximately equal to the amount of each monthly payment that goes toward interest? How can this crossover payment number be directly calculated. On which payment number does the crossover occur?
Thanks for the great web site.
– Steve Gibson
Atlanta, GA
678-778-6790