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Megan is with us in Bakersfield, California. Hi Megan, how are you? I'm doing better than I deserve. How can I help?
Okay, so, one, I just have a pretty weird personality, so I might get crazy here. But we're on the tail end of Baby Step 2. We only have about $3,600 left on one bill, and my husband is finishing the last of his prerequisites to start nursing school. We plan on bankrolling that the whole way through with help from our parents, and we don't want to take out loans.
Good. So I'm more of a future planner. I don't like to think about just where we're going to be in five years. I'm thinking more about the mortgage when my husband graduates, because we'll have a much larger income. I have heard a lot about prepaid interest or prepaid principal, and they don't really understand how that works. I was watching the Pill method, and then he was talking about taking out loans, and I was like, this guy's not listening to it, but that's kind of where I was. That was: how do principal payments work?
Yeah, it makes it sound like there's some kind of magic to it. There's nothing magic to it at all. You take the interest rate of your mortgage and you divide it by 12. Okay, and you multiply that times the outstanding balance that month. That is the interest charged that month. Does that make sense?
Mm-hmm.
And the rest of your payment goes toward principal. So let's just make up some easy numbers. Let's say a 6% interest rate, which would be very well... let's say 3% interest rate. Okay, that's current. That's a quarter of a percent, 0.25 per month, if you divide 3% by 12. Okay, you'll get a quarter of a percent per month. So if you had a hundred-thousand-dollar loan, just to make the numbers real round because it's a good lesson to walk through, you'd say 0.025 is your... oops, I did that. It's 0.025, still not doing that right. A hundred thousand, but I put too many things in the calculator one time. Point zero two five. There we go. Okay, there we go. Two hundred bucks. I should be able to do that in my head.
All right, anyway: two hundred fifty dollars of your payment that month, if you have a hundred-thousand-dollar balance, that three percent would go toward interest, right?
Okay. Now let's say your payment was three hundred and fifty dollars. It wouldn't be... let's say it's four hundred and fifty dollars, okay?
Okay.
And so, $250 went to interest. The other $200 would pay down the $100,000. Does that make sense?
Yeah.
The next month, your interest is calculated on ninety-eight thousand eight hundred dollars at a quarter percent. So instead of being two hundred fifty dollars, I'll make up a number. Let's say it's two hundred forty-seven dollars. Okay. But your payment is still four hundred dollars, just a little less going to interest, so a little more goes to principal. So instead of paying two hundred dollars toward principal the next month, in our example it might be two hundred and three dollars. Do you follow me?
Okay.
So every time you pay principal, that makes your next payment have more going toward principal and less toward interest. So say, for example, I was gifted a thousand dollars for, I don't know, just being amazing to somebody, and we went and put that on the principal. Yes?
Would that change our payment the next month?
No. Your payment stays the same. It changes the amount of interest. Interest would go down because you're going to be charged interest on a thousand dollars less. You're not paying interest on that thousand dollars anymore.
Okay.
So your payment would stay exactly the same, but more of your payment would go toward principal. You don't have as high an interest charge because you don't have as high a balance. Your interest is calculated on the balance each month. You pay your interest rate only on what's outstanding. So if you throw ten thousand bucks at a mortgage, you don't pay interest the next month on that ten thousand. It saves you the interest on that ten thousand. Your payment stays the same, so a lot more of your payment would go toward principal the following month than it did before.
That's why sometimes people say, "Oh, I've already paid all the interest, so I don't want to pay my mortgage off because I've already paid all the interest up front." No, you didn't. You only pay interest on what's outstanding. Once you've paid on the mortgage for years and years and years, and you've paid the principal down, your payment is still the same, but much, much more of your payment goes toward principal. After 15 years on a 30-year mortgage, that's the 28th year of a 30-year mortgage, exactly.
Okay. Yeah, this is the kind of stuff they should teach in high school, because nobody taught me that.
Yeah, that's exactly right. Well, good news: 36 percent of the high schools in America now carry a Dave Ramsey high school curriculum called Foundations of Personal Finance. So we've got a little over a third of them, but we've got the other two-thirds to go. You're exactly right. That's called a simple interest calculation, which I just walked through with you, and that's how any mortgage is calculated.
Have you ever seen the tables printed out on a mortgage payment, where it shows the columns, shows your payment, shows how much is going to interest, how much is going to principal? You slide your finger down the page, and you're like, "Wow, a whole lot more after paying 120 payments, paying ten years, a whole lot more is going toward principal and less toward interest." Do you follow me? If you've ever seen that, so what happens is, if you want to do this easily without having to do the raw math, if you pay $10,000 on your balance, you just slide your finger down the outstanding balance and find your payment number. Say it's payment number 37 when you did it. Then you pay $10,000, and you're going to drop down. It might be looking more like payment number 61. That's going to be your next payment. So you're just knocking out chunks of payments. It's calculated as payments 61, or wherever the balance is closest to the new balance after you paid your $10,000 down. It's an item that really helps a lot.
I was super worried about it because I really want to get it paid off within about 10 years after he graduates.
Yeah, that's why throwing money at the mortgage early and often, when you get to Baby Step 6, is so important. But it's also why you don't need to do more than once a month, because they only recalculate once a month. Mortgage payments are monthly payments, so if you send four payments in a month, it doesn't change the math at all. They all go toward principal, but you might as well just send one check.
I've seen these groups with supposed systems, where they've gotten all this BS where you just start sending payments, and you don't want it. You want to send one a week, and now it doesn't work, because the calculation is done once a month. It is 1/12 of the annual interest rate per month. It is not a daily or a weekly calculation on mortgages. Now, some credit cards are calculated daily, and some are calculated twice, three times, or four times a month, so they're a little different. But anything that's calculated once a month, paying on it more than once a month does not change the math. Do you understand?
Yeah.
Cool. It's good to talk to you. Thank you for calling. That's a good question.