Paying down your debt early is often a great idea. However, things might not work out exactly as you expect them to if you put this payment toward your mortgage in one lump sum. Before you send funds, learn how extra payments affect the following:
Your total interest costs The time it takes to repay your loan Your monthly payment
Interest Costs
Making a large early payment on your mortgage will reduce the amount of interest you pay on your loan. You’ll have a smaller loan balance, and interest is charged against your loan balance, so you’ll pay less. Over many years, that will result in significant savings—especially if you’re in the early years of a long-term loan like a 30-year mortgage. With amortizing loans (or loans that you pay down over time with fixed payments), most of each monthly payment goes toward interest costs. Gradually, more and more goes toward principal repayment. To figure out exactly how much you’ll save, you might need to do a bit of math. But the math isn’t horrible, and it’s helpful to understand how your loan works and how you can save money. If you model your loan on a spreadsheet, you’ll see how the loan works: your monthly payment, monthly interest costs, and shrinking loan balance. Simply reduce the loan balance at some point in the spreadsheet that corresponds with where you are today. For example, if you owe $100,000 and are thinking of paying $20,000, to reduce your loan balance to $80,000, the spreadsheet should automatically re-calculate the rest of the loan for you, and you should see reduced interest costs.
Time to Repay
Most mortgages are 15-year or 30-year fixed-rate mortgages, with a 30-year mortgage being the most popular. Over time, you’ll slowly pay down your loan balance. However, you can always speed things up as long as there’s no prepayment penalty (a fee you must pay if your loan is paid off before its term). If you make a lump-sum payment and don’t recast the loan (see below), you’ll pay off the loan more quickly and save money on interest. Those monthly payments will simply end sooner, so you can put those funds toward other goals. Again, using the calculations linked to above, you can run the numbers, and you’ll see that the loan just ends early.
The Monthly Payment
If your main goal of making a lump-sum payment is to lower your monthly payment, then you might be in luck. But mortgage companies don’t necessarily adjust your payment when you pay extra–sometimes you have to request a recalculation and pay a fee. This process is known as “recasting a mortgage.” Some people are disappointed after they send huge payments to their mortgage lender, only to find that the required monthly payment has not changed. Be sure to ask your lender what is required in order to adjust your monthly payment. If you have an interest-only mortgage, the odds are better that your monthly payment will automatically be reduced. After all, your payment is based solely on the amount of the loan (which never changes unless you pay extra). However, even interest-only loans don’t always adjust immediately, so call and ask how things work.
