Ultimately, applying an extra lump sum payment towards your mortgage will alter the course of the amount of overall interest you will end up paying for the money you borrowed.
Let’s say for example that you started a loan last month – $200k @ 5.5% for 30yrs. Principal and Interest payments for that loan would be $1135.58/mo. Based on an amortization Schedule from day 1 your payment would break down into $917 of that payment going towards interest and $219 going towards principal. Each month those numbers will change by about a dollar…so for example your 2nd month payment of that payment $916 will go towards interest and $220 towards principal.
Let’s assume that after you’ve been into the loan for 12 months you’ve come into some money and now have $10,000 to put towards your mortgage balance. Applying this money will go directly to your principal balance minus the interest that is owed for that month’s payment. If you’ve made your normal payment in addition to the $10k…no big whoop.
After 12 months of normal on-time payment your payment now breaks out to – $905 Interest and $230 Principal.
Here’s the cool part – After your $10,000 payment, although your payment will not recast (meaning it will stay the same as you are used to) more of your payment now will be going towards the principal balance than previously has been. Now your payment breaks down to – $858 Interest – $277 Principal. As you can see now, each month you make your payment, you are putting an additional $47 more directly towards the principal balance than you would have been.
Keep in mind, too, you are now on track to pay your loan off around 4 years early because of that lump sum payment. 48 payments x $1135.58 = $54,507 – $10,000 lump sum = $44,507 net benefit! That’s a whole lot of moola you end up saving!
Hope this helps!
The benefit is the amount that you pay down your pricipal by will be money that your current mortgage lender cannot charge you interest on now. So if your lump sum was say 50K and your interest rate is 6% you would be essentially saving the amount you would have accrued in interest. Not to mention you would also pay off your mortgage much quicker! On a traditional 200K 30yr fixed mortgage that is at 6% and you paid a lump sum of 50K at the start you would essentially cut about 163 months of payments off your mortgage that is over 13 years off your term assuming you continue to pay your monthly payment and do not refinance. This in essence saves you 195K in monthly payments less your investment of 50K, the realized savings is 145K. That is HUGE! On the other hand if the payments are out of reach for you paying this down and refinancing could be a viable option to reduce your monthly payments as well. (I don’t like this idea as much…)
Prior to doing this I would make sure you have substantial emergency funds, and you consult a licensed financial planner. If you you invested the money and were able to average a 10% return (may be tough!) using the law of 72 your money would double every 7.2 years so in a little over 14 years you would have 200K.
In all the money you have for a lump sum has a value no matter where you put it, it just depends on your personal situation that may dictate if you should pay down your mortgage or not.
The main benefit of paying down the mortgage with a lump sum is that you will pay your loan off early by adding additional principal. It is said that if you pay one extra payment per year you will shorten your loan term to roughly 23 years vs. 30 years.
Without knowing how much you are thinking of putting down it is impossible to tell you how much quicker this will pay off the loan, the guideline above gives you an idea of how it works.
On a fixed rate loan this will have no effect whatsoever on your monthly payment since it is installment debt not revolving like credit cards.
It will howver have the effect of lowering your payment if it is paid on a home equity line of credit, which acts like a credit card in that the principal reduction will lead to a payment reduction.
This may be a complex question, depending upon your financial circumstances, goals, and timeline.
The most obvious “benefit” of a lump sum paydown is that every dollar that you pay early will not accrue interest for the remainder of the loan.
If you take out a $100,000 loan for 30 years at a fixed rate of 6%, your monthly minimum payment (principle and interest only) should run you about $600 a month. Over 360 months (30 years), you will pay a total of $215,838.
If you opt instead to make a lump sum payment of $50,000 at the end of the 3rd year, you will continue to make the same minimum payments – but the home will be paid off in only 11 years instead of 30, and will only have paid a total of 129,890 for the loan – saving $85,948 in interest!
The earlier in the loan term that this principle is prepaid, the more substantial your interest savings will be.
If you have an adjustable rate loan, or one that has interest-only payments, your pre-payment of the loan in a lump sum may cause your payments to recalculate (“ recast”) to a lower figure – for instance, on that same $100,000 loan, if you were making interest-only payments (no principle), your monthly interest would be only $500. After you reduced the loan by $50,000 at the end of the third year, your minimum payments would drop to $250.
Prepaying your loan also puts you in a better “ equity position” – ostensibly raising your net worth by reducing your debt.
It is important to not, however, that there may be market DISADVANTAGES to prepaying your loan. Prepaying may alter the way that you claim the home on your taxes and could change your tax bracket. The lump sum may also have been better invested to pay off other, higher rate debt or to invest in a vehicle that offers a higher return than the rate you are paying on your home. Before making any drastic financial decision, it is always best to consult both your accountant or tax preparer and your financial advisor to make certain that you are maximizing your financial opportunities. For many, pre-paying their mortgage (especially the loan on their personal residence) is not always the most efficient or most beneficial use of spare funds.
1. There is a reduced cost of interest in the long term, by ending mortgage payments sooner. To use an actual example: Loan balance $250,000, 30 yr term, 6% interest, P&I payment $1,498.88. Lump sum deposit of $25,000 results in loan ending in 23.2 yrs.
2. If the lump sum payment is large enough, the lender may agree to reamortize the loan, and reduce the monthly payment. There is often a small fee to do this ($100-$200). Using same example above, the payment could be reduced to $1,348.99, while the length/term would remain the same. Figures are examples only, actual results almost will certainly be different.
- It keeps you from blowing the lump sum in Vegas :)
The question to ask yourself should be: Is there anywhere that I can put the money to better use?
Applying the lump sum to your mortgage has a significant return and benefit, but it limits other investment or enjoyment opportunities.
One other minor factor in NOT paying down the principal is the loss of an income tax deduction benefit. By paying down the principal, the interest you pay will be reduced, and your subsequent deduction would also be reduced.
The benefit will be a reduction in your term. What this means is you will end up paying off your home far sooner than originally anticipated. The reason is by making a lump sum payment towards the principle you interrupt the amortization schedule. Your monthly payments will not go down, but becuase you now owe less against your home, a much larger portion of that payment will be applied against the principle month after month after month. Consequently, you will end up paying less in interest (because you have paid the loan off faster), and you will becomes a free and clear owner far sooner than most give credit for.
Consider this, a truly bi-weekly payment shaves on average 7 years off a 30 year mortgage, a point I make so one can compare how much impact a lump sum can have on the remaining term. Since the term is ultimately the most costly component of any given loan, reducing it whenever possible is never a bad idea. To prove this point consider two 200,000 dollar loans one a 30 year fixed, the other a 15 year fixed. The 30 year has an interest ate of 5% and a payment of 1,073.64, over 30 years you will have paid 386,511.56. The same loan on a 15 year fixed at 6% interest has a payment of 1,687.71, you will pay over 15 years 303,787.80… despite the higher interest rate, you save yourself 82,723.76 in interest paid because of the reduction in term.
One point to consider however is real estate value. In essence you have currently surrendered part of your equity to the bank, and in doing so they have taken some of the risk involved in the investment. By paying down the principle you are assuming more risk in relation to deflation. Imagine paying in 50,000 only to discover property values, drop 25,000 the following month. This is important to consider especially if you do not have long term plans for the home.
All things considered owning your home free and clear is never a bad idea, and paying down the principle to accomplish this goal faster is an understandable investment.