A friend of mine is in the process of purchasing a newly built home. Between the realtor and the builder, my friend is getting some very bad information and as thus, I have been trying to advise a little. Don’t think anything is sinking in – but, at least I am trying.
Yesterday, this friend told me that his builder told him that if he pays one additional payment a year (a 13th monthly payment) he could have his loan paid off in half the time.
Now, I remember hearing something very similar to this years ago – that if you add one additional principal payment each year – you can cut a 30 year mortgage term down to 15 years.
Now, when I heard this – I never really investigated it – was just more interested in buying the house.
But, this got me thinking – does this really work? Or, is this just another way that realtors and builder blow smoke to ensure that THEY get what THEY want?
Now, I know that a lot of paying down any debt is in part determined by the amount of that debt, your interest rate and your term. But, I thought I would do some very unscientific calculations to see what really would happen if you added extra payments.
Here are my findings:
I took a simple loan (meaning simple interest loan) at $150,000 with a 5% interest rate for 30 years (360 monthly payments).
1) I then added an extra payment (full payment- not just the principal portion but the full payment) and applied that amount as principal only.
By adding this payment (at the end of the year) – it reduced the term by approximately 4.5 years. Not really cutting the payment in half.
2) So, maybe it has to do with timing – so, I went back and added the same full payment to the beginning of the year.
This only reduced the term by 3 additional months for 4.8 years. This is still under 5 years of term reduction and no where near cutting the entire term in half.
3) I then went back and tried different interest rates. Now, the higher the interest rate, the larger the extra payment (still using the entire payment amount to reduce principal).
By doubling the interest rate to 10% – the term was reduced by just over 9 years.
The higher the interest rate – the more impact your extra payment (full payment) will have at reducing your loan term.
4) But, what happens if you only add – as an extra payment – the principal portion?
Since we already know that adding the extra payment at the beginning of the year provides the greater benefit (as opposed to the end of the year) – we will stick with doing that from here on out.
Adding just the principal amount – at the 5% rate – the term savings (the amount of time cut off your mortgage term) would only be 2.25 years (compared with 4.8 years) – which is intuitive as a smaller amount was added as extra principal.
At the 10% interest rate, the term reduction drop from just over 9 years with full payment added as an extra payment to the same reduction at 5% – amounted to only 2.25 years. Again, this should make sense, intuitively.
Paying more (i.e. the full payment – not just the principal amount) will result in more of a reduction impact on your loan’s term.
5) Now, what happens if we increased the loan amount by $100,000?
At the 5% interest rate – adding in a full payment, once a year (at the beginning of the year) still only reduces your term by under 5 years – no where near cutting your term in half.
At the 10% interest rate – there really was no significant difference at the higher loan amount.
The amount of the loan does not significantly matter when adding additional principal payments as outlined here.
So, what should one do to cut their loan term in half – be is mortgage or a business loan?
Going back to our original loan amount ($150,000) and our original interest rate (5%) – to actually cut your term in half (while only making one extra payment per year – at the beginning of the year) – you would have to make an additional payment of $4,468.60 at the beginning on each year for 15 years. As your normal monthly payment is only $805.23 – this extra annual payment approximates to an extra 5.6 full payments each year (all payable at the beginning of the year).
If you are looking to pay down your debt as fast as you can:
1) Never believe someone who has an interest in something that does not align with yours – like the builder, your lender or your realtor.
2) If you want to reduce your overall term – which also reduces the total amount of interest you will pay over the life of a loan – add as much extra principal that you can whenever you can. Do not fall for some set schedule – like once a year.
3) If you can only add a few extra payments each year – do so as early in the year as possible – do not wait (it is a time value of money thing).
4) Always pay down your higher interest loans first with your extra payments – regardless of amount owed.
While this unscientific analysis was done on a 30 year mortgage loan – if your loan is a simple interest loan – these conclusions will apply no matter what the loan is used for – i.e. your personal needs or for your small business.