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A discussion on how your loan amortizes may not seem exciting, but we promise to keep the math light. The upshot is that a basic understanding of your mortgage payment, and the breakdown between interest and principal, could result in a cumulative savings of thousands of dollars for you.
The mortgage payment
When you apply for a mortgage, your monthly payment typically consists of principal, interest, taxes, and insurance. For a fixed rate mortgage, your interest rate does not change for the life of the loan. This means the first two components will not increase or decrease. Taxes and insurance can change, typically upward, which is why your monthly payment will not be the same over time.
The national 30-year mortgage rate was 3.83%, according to Freddie Mac. In New York City, it was around 3.79%, based on other sources. There are several online mortgage calculators, or you can choose to build your own using a program such as Excel to figure out your mortgage payment.
Using a hypothetical example, let’s say you decide to purchase a $750,000 property and place a 20% down payment. Your loan is $600,000. Therefore, your monthly payment (principal and interest) is $2,795.74, assuming a 3.8% rate and a 30-year mortgage.
If you plan on taking out a 15-year mortgage, the average rate is 3.15%. Your monthly payment jumps to $4,186.91. While this is a substantial increase over your payment for a 30-year mortgage, keep in mind you will pay a lot less interest, as we will demonstrate.
Using the same numerical examples, over the life of your 30-year mortgage, you will have paid $406,467.88 in interest. On the 15 year mortgage, your total interest payments amount to $153,644.19. This equates to $252,823.69 less interest that you will have paid. Keep in mind, we are in a historically low-interest rate environment. At higher rates, you will have shelled out more interest to the bank.
However, not everyone can afford the extra amount every month required for a 15-year mortgage. Alternatively, you may decide you like the flexibility of having a lower payment with a 30-year mortgage. There is still a step you can take to lower your interest burden as well as shaving time off your loan.
You can opt to prepay your mortgage. That is, you can decide to make extra monthly payments, applying the amount to the principal balance. In New York State, there are limitations, but these apply to mortgage loans with greater than a 6% interest rate. While most lenders do not charge a prepayment penalty, you should ask your bank.
On your 30 year mortgage, very little of your initial payments pay down principal. For your very first $2,795.74 payment, only $895.74 goes towards the principal while more than double is an interest payment. Gradually, there is less interest (since the principal balance is lower), but this is a slow process. For instance, an extra $3 goes towards your principal for your second monthly payment. After roughly 12 years, you pay more principal than interest.
Prepaying allows you to lessen your interest burden while cutting down on the length of your loan. If you can manage to pay an extra $100 every month, your total interest is $377,722.91, or about $30,000 less than making your regular payment. You will also have paid off your mortgage about two years early.
If you can scrape together $200 a month to apply to your principal balance, your total interest paid is $352,978.759, and you have shortened your loan term by about three and a half years.
There is no reason you cannot make extra payments on a 15-year mortgage, although your payment is higher than a 30-year mortgage, so you have to examine your budget closer.
Prepaying your mortgage with extra monthly payments can create large savings and give you the satisfaction of complete homeownership earlier. However, strictly from a financial perspective, there are other factors you should consider, such as the after-tax return you can receive the extra payment compared to the after-tax interest cost.