Dear Dr. Don,
We recently closed on a 20-year mortgage. We would like to pay it off in just over 10 years by adding an extra $415 per month to the principal. Is it better to make the additional principal payments monthly or do it as a lump sum annually, making a $5,000 payment every December or January?
Our mortgage is at 5 percent and the loan amount is $150,000, which we started paying April 1, 2009. I used Bankrate's amortization calculator and there isn't much difference between the two approaches. I estimate it's only about $500, but I would prefer to have the money in our savings account every month just in case something unforeseen happens and we need cash quickly. We currently do this with our property taxes and I am very disciplined about putting the money away every month.
The other question I wanted to know is if paying extra monthly or yearly has an impact on the remaining interest on the loan or on our tax return every year. Please advise.
-- Lyn Line-Item
Dear Lyn,
When you make additional principal payments on your mortgage loan you reduce the loan balance and that reduces the interest expense. Your required monthly payment doesn't change. What changes is the breakdown of the payment between interest expense and principal repayment.
Less interest expense means more of the monthly payment is going toward the repayment of principal. The result is lower total interest expense plus a shorter loan term. Like you, I used Bankrate's Amortization Schedule Calculator to see how the different additional principal payment strategies changed the total interest expense and the life of the loan.
My results, shown in the table below, are different from yours, in part because I assumed that the additional monthly payment was $416.67 ($5,000 divided by 12) instead of $415, but they're close to your figures.
Principal payment strategies
|
| Additional principal: | -- | $5,000 | $416.67 |
| Total payments: | $237,580 | $199,962 | $198,774 |
| Total interest: | $87,580 | $49,962 | $48,774 |
| Difference: | -- | $37,618 | $1,188 |
| Loan term (years) | 20 | 11.83 | 11.83 |
I like the approach where you're making the additional principal payments each month. I feel this way in part because if you're saving up to make a lump sum payment at a later date, you're probably holding the money in a bank account earning less on an after-tax basis than the effective rate on your mortgage.
Making additional principal payments does reduce the interest expense and by doing that, reduces the mortgage interest deduction on your income taxes. For most homeowners, that's OK because a reduction in the mortgage interest deduction isn't all that important to them.
In very rough terms, not paying the additional $50,000 in interest expense means you could pay about an additional $12,500 in income taxes over the life of the loan. (This assumes a 25 percent marginal federal income tax rate and itemized deductions that more than exceed the standardized deduction.) You're still $37,500 ahead even with the loss of the tax deduction.
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