What Happens If I Make an Extra Mortgage Payment a Year?
Understand the long-term financial impact of making an additional mortgage payment annually. Shorten your loan and save money.
Making an extra mortgage payment each year can significantly influence your home loan. This strategy involves contributing more than the standard monthly amount towards your mortgage. Such additional contributions can lead to substantial savings and accelerated homeownership. The decision to make extra payments is individual, often driven by a desire to reduce debt and build equity more quickly.
Understanding Mortgage Principal and Interest
A mortgage payment consists of two components: principal and interest. The principal is the amount borrowed, which gradually decreases with each payment. Interest is the cost charged by the lender for providing the loan. These elements form your monthly mortgage obligation.
The allocation of principal and interest within each payment changes over the loan’s life, a process known as amortization. Initially, a larger portion of each payment goes towards interest, while a smaller amount reduces the principal. As the principal balance declines, the proportion shifts; more of each payment applies to the principal and less to interest. This ensures the loan is paid off by the end of its term, assuming only scheduled payments are made.
Lenders calculate the monthly payment amount to amortize the loan over its term. This calculation is based on the original loan amount, interest rate, and loan term, typically 15 or 30 years for fixed-rate mortgages. While the total principal and interest payment for a fixed-rate loan remains constant, the balance between these two components continuously adjusts.
The Mechanics of an Extra Payment
An extra mortgage payment directly applies to the outstanding principal balance. This sum bypasses the scheduled interest portion of future payments and immediately reduces the amount upon which interest is calculated. Since interest is computed based on the remaining principal, lowering this balance ahead of schedule decreases the total interest accrued over the loan’s life.
This principal reduction creates a compounding effect: less interest is charged, allowing more of the regular payment to go towards the principal. The regular monthly payment, including principal and interest, generally remains unchanged after an extra payment. However, accelerating principal reduction shortens the loan’s overall term.
Paying down principal faster also accelerates home equity build-up. Equity is the portion of the property truly owned, calculated as the home’s value minus the outstanding mortgage balance. Increasing equity quickly provides greater financial flexibility and security.
Calculating the Financial Effect
Making extra mortgage payments offers two primary benefits: reduced total interest paid and a shorter loan term. For instance, a $200,000, 30-year fixed-rate mortgage at 4% has a monthly payment of approximately $955, totaling about $143,739 in interest over its life. Adding an extra $100 to each monthly payment could cut the loan term by over 4.5 years, saving over $26,500 in interest. An extra $200 per month could reduce the term by over 8 years and save over $44,000 in interest.
Even a single extra monthly payment made once a year can have a substantial effect. For example, on a $400,000 mortgage at 6.8% with a $2,608 monthly payment, one additional $2,608 payment annually could shorten the loan to 24 years, saving $126,000 in interest. Adding just $50 extra each month on a $250,000, 30-year mortgage at 5% interest could save over $21,000 and pay off the loan two years and four months earlier.
Online mortgage payoff calculators can determine specific savings. These tools allow users to input loan details like remaining balance, interest rate, and original term, then specify an additional payment. The calculator projects the new payoff date and total interest saved. The earlier extra payments begin in the loan term, the greater the potential interest savings, as the compounding effect has more time to work.
Methods for Applying Additional Funds
Homeowners have several ways to make additional mortgage payments. One common approach is a lump-sum payment from a tax refund, work bonus, or other unexpected income. This is a one-time contribution directly applied to the principal. Another method is to integrate smaller, consistent extra amounts into each regular monthly payment, such as rounding up the payment or adding a fixed sum. For example, dividing one extra monthly payment by twelve and adding that amount to each regular payment throughout the year achieves an extra annual payment.
A popular method is establishing bi-weekly payments, where half of the monthly mortgage payment is made every two weeks. Since there are 52 weeks in a year, this results in 26 half-payments, equating to 13 full monthly payments annually instead of the standard 12. This adds one extra full payment to the principal each year without requiring a large one-time sum.
Regardless of the method, explicitly instruct the mortgage servicer to apply additional funds directly to the principal balance. Without this instruction, the extra money might be held as an early payment for the next month’s bill, not yielding interest savings or accelerating the payoff. Most lenders offer options through online portals, phone, or mail to designate principal-only payments. Before making extra payments, review loan documentation for any prepayment penalties, though these are uncommon for most standard mortgages.