There's nothing quite like the excitement of finding and buying your dream home. You found a home within your budget, set aside a down payment and found a mortgage at a stellar rate. But did you know over the course of that 30-year fixed-rate mortgage, you'll end up paying almost as much in interest to the bank as you will toward the house itself? That is, unless you know how to beat the system.
Here's the scenario: You take out a 30-year, $300,000 fixed-rate mortgage at 5% interest. That comes out to a monthly mortgage payment of $1,610.46 (not including taxes, insurance, and private mortgage insurance, if you need it). Sounds pretty reasonable, right? Not so fast. Make that payment 12 times a year for 30 years (360 times total) and you're looking at a total of $531,451.80. Yes, over the life of your mortgage you'll be paying more than $230,000 in interest alone. Ouch.
You may think, "OK, most of my $1,610.46 payment must at least go towards the principal, right?" Unfortunately not.
"The interesting part of amortization is that every mortgage payment [you pay each month], despite being equal, contains different amounts of principal and interest," says Sam Fannin, residential mortgage loan originator at Premier Nationwide Lending in Dallas-Fort Worth, Texas.
In our mortgage example, your first payment looks like this: $1,250 interest + $360.46 principal. According to this amortization table, you're paying more interest than principal until the 17th year of paying your mortgage.
So, in the last two minutes have you been thinking about all the things you'd rather do with that $279,770 than pay it to your bank in interest? Good, because you definitely can chip that amount down substantially. And here's the sweet thing about it: You don't even have to be a cash-rich millionaire OR have cash-rich millionaire parents! You just have to give your mortgage payments a little bit of thought. Here, three easy strategies to beat the interest game and save substantial amounts of money.
1. The Biweekly Payments
Instead of making one mortgage payment per month, make half the payment every two weeks. In our $300,000 mortgage scenario above, you'd make a $805.23 payment every two weeks. By doing this you'll end up making the equivalent of one extra mortgage payment per year without even realizing it. Depending on the interest rate, that one extra mortgage payment per year could knock eight years off the life of your mortgage, Fannin says.
2. The Larger Mortgage Payment
The earlier in the mortgage you do this, the better, according to Nick Lumpp, president of RCN Wealth Advisors in Maryland. "Extra money toward the principal in year one goes further than in year two, and so on," he says.
There are a few ways to approach this one:
- Buy a house under budget, but make payments on par with what you can afford.
One of the easiest ways is to start thinking about your payment even before you find a home. Lumpp offers this strategy: Figure out what you can afford for a mortgage payment in terms of your monthly budget and then get a mortgage that's no more than 75% of this amount. So, for example, if you can afford to pay $2,200 towards your mortgage payment each month, settle for the mortgage that only costs $1,650 a month. Then, pay the extra 25% you can afford towards principal each month when all is well. Things get tighter? You can pay the "lower" monthly payment (i.e. the actual required monthly amount) without any penalties. By paying an additional $550 a month, you'll save more than $130,000 over the lifetime of the loan in interest and pay off your mortgage nearly 13 years earlier.
- Round up!
Want a bigger house? Can't find a less expensive option in your area? Just round up your mortgage payment to the next highest $100 amount, says Fannin. In our example, you'd pay $1,700 instead of $1,610.46. That extra $89.54 a month will save you more than $36,500 in interest and cut the length of your mortgage by three years and four months.
- Gradually increase (or decrease) your monthly payments.
Will even $80+ a month make things tight? If your income increases slightly but consistently over time, such as a cost-of-living raise, try the dollar-a-month plan. It's just like it sounds: Increase your payment by $1 each month. For example, if your mortgage payment is $1,610.46 per month, you would pay $1,611.46 in month one, $1,612.46 in month two, and so on. For a 30-year, $1,610.46-per-month mortgage, you would reduce the term of your mortgage by four years and save more than $37,000 dollars.
And if you don't mind paying more upfront, you can reverse this method and tack on the extra money up front and save even more (since you're paying down the principal quicker). So instead of paying $1 more in the first month, you'd pay an extra $360 (or $1,970.46), and then an extra $359 in the second month (or $1,969.46). This method would save you more than 7.5 years in payments and nearly $87,7000 in interest!
3. The Big Extra Payment
Both Lumpp and Fannin agree that putting a large chunk of money toward the mortgage principal at least once each year is an effective strategy: think holiday bonuses, inheritance, tax returns, a raise at work, or just money you saved up over the year specifically for this purpose. This strategy is particularly effective because it doesn't eat into your regular monthly budget.
By making just one extra payment per year in the amount of your normal monthly mortgage payment, you can shave almost an entire year's worth of interest off your mortgage. Just remember that the earlier into the life of your mortgage you do this the more effective it is.
With all of these strategies, it's important that denote with your lender that any extra money you pay on your mortgage goes toward principal. Unfortunately, some lenders charge penalties to paying off your mortgage early—really!—so it's best to check your loan agreement's terms and conditions. Once you're sure you can pay early, Fannin says there are a few ways to ensure your money is going where you want it to.
1. If you pay your mortgage online, there should be an option on the payment page to make an additional payment and to specify that it should go to principal.
2. If your mortgage is automatically withdrawn each month, simply call the bank and tell them you want them to withdraw an additional X amount and that it goes toward principal.
3. If you pay your mortgage by check, write on the memo line how much of the larger payment should be applied to principal.