Last week I wrote about why buying a home in your youth isn’t necessarily the best course of action. But what if you have already purchased a home or are planning to in the near future? Luckily there are strategies you can use to potentially save thousands of dollars over the length of the mortgage!
THE SHOCKING TRUTH
I remember the first time I saw the amortization schedule for a mortgage. I was blown away!
An amortization schedule is a long financial statement included in the loan document that shows all the payments you’ll make over the course of the loan. It also includes the total amount of principal and interest you will pay.
Over the course of a 30-year mortgage, it isn’t uncommon for the total you pay the bank, including interest, to amount to DOUBLE the purchase price.
This can have a big drag on your ability to build wealth over the course of your life. So how can you minimize this?
Luckily, there are some interesting strategies you can potentially use.
SMALL CHANGES MAKE A BIG DIFFERENCE
In the book, “The Banker’s Secret” by Marc Eisenson, he discusses a strategy called “pocket-change prepayments.” The concept is based on making additional principal payments each month to decrease the amount of interest you pay over the life of the loan. By doing this you also shorten the length of the loan, meaning you make payments for a shorter period of time.
Making principal payments isn’t a groundbreaking concept. People have been talking about it for a long time. In fact, Mr. Eisenson’s book was published in 1990!
What is interesting is HOW MUCH you can potentially save by doing this.
There are two main strategies to implement:
1. Send extra money to pay down your principal faster.
In this scenario you will have to come up with more money each pay period, but this will have a significant affect on your savings.
2. Set up your payments to debit bi-weekly instead of monthly.
In this scenario you will be making more payments throughout the year (Although they will be for a smaller amount), which will increase your total annual payment.
- Monthly: 12 Payments
- Bi-Monthly: 24 Payments
- Bi-Weekly: 26 Payments*
*Two extra payments each year
POCKET CHANGE IN ACTION
Let’s look at an example:
(For the below example, I’ve eliminated taxes and insurance to focus solely on the loan numbers and to account for differences from one part of the country to the next.)
Let’s assume you buy a home with the following numbers:
- Home Price: $252,500 (Current median price of a single-family home)
- Interest Rate: 3.92% (Mortgage Rate Data)
- Terms: 30-year fixed
- Down Payment: 20%
Your monthly payment would be $955.09. The total interest you would pay over the course of the loan would be $141,830.87, bringing the total cost of the home to $394,330.87.
In this scenario you will have paid over 56% more than the actual price of the home.
Bear in mind, this is with mortgage rates near all-time lows.
In the first strategy you pay extra on the principal. If we pick $100 extra per month as our agreed upon amount, what would happen?
- Interest Savings: Over $26,000
- Time Savings: 4 years and 10 months less of payments
You’ll remember that in this strategy we are looking to make payments more frequently. So, instead of making a once-a-month payment of $955.09, you pay $477.54 every two weeks.
The key is to make sure your bank allows this and to make sure they are properly crediting the payments so they amortize on this new schedule. You don’t want them to hold your money until the end of each month and then credit it all at once as if you had made only one payment. This won’t provide you any benefit.
So, what would happen in this scenario?
- Interest Savings: $22,771
- Time Savings: 4 years and 1 month less of payments
These savings come from a relatively small increase in payments and a very low interest rate. For those with more expensive homes and higher interest rates, the positive effect will be even greater.
This same principal can also be applied to other forms of debt, including credit cards, auto loans, and student loans.
So start crunching the numbers and see how much you can save!