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Intro
In this video I'm going to tell you the truth about mortgage interest and show how to pay off your mortgage early. With this knowledge, you can save a ton of money by reducing the amount of interest that you'll pay and finish paying off your mortgage years ahead of schedule.
I'm the former Chief Financial Officer of software companies. I've got an MBA from Cornell University and am a chartered financial analyst. I enjoy sharing what I've learned to help people improve their finances. If you know how money works, you have a much better shot at building wealth.
I'll start this video by quickly showing you how the interest on a mortgage is calculated. Once you understand that, you'll understand why the strategies that I'll show you next to pay off your mortgage faster work. Finally, at the end of the video, I have a summary table that compares the strategies side by side using different mortgage interest rates. This is powerful stuff, so let's get into it.
How Interest Affects a Mortgage
When considering whether they can afford to buy a house or an apartment, people tend to focus on the monthly payment. Can I afford it? That's important, but they should also think about the interest rate on the loan. Obviously, the higher it is, the more you'll pay. What you might not realize, though, is just how much money and interest you'll be paying over the life of the mortgage.
To be fair, you don't think about it because the banks don't make much effort to show you the interest costs. The interest is hidden inside the payment, so I'm going to show it to you now.
Here's what you need to know. The monthly payment for a mortgage loan has two parts. First, you've borrowed money, so you need to repay that money over time. The money that you borrowed is called the principal. So the first of the two parts making up each loan payment is paying back a piece of the borrowed money. Second, when the bank lent you that money, you agreed to pay interest on the loan. The second part of your monthly loan payment is interest on the borrowed money, meaning interest on the principal that you have not yet paid back to the bank.
So each monthly payment that you make on your mortgage is partly paying back some of the principal and partly paying interest on the unpaid principal balance. It's actually kind of shocking how much money you'll pay in interest over the life of the loan. In fact, depending on your interest rate, the amount of interest you'll pay could be close to, or even more than, the amount that you borrowed, which is massive considering that you probably borrowed hundreds of thousands of dollars.
Get this: if you borrowed $250,000 on a 30-year mortgage and your interest rate on the loan was 4%, you will pay $180,000 in interest by the time you paid off the mortgage. At a 6% interest rate, you will pay $290,000 in interest over the life of the loan, and at 8%, you will pay $410,000 in interest. Like I said, kind of shocking.
Let's now quickly look at how the interest is calculated on a mortgage so you know where these numbers are coming from. Once you know that, it will become clear how to reduce your interest cost and pay off the loan faster. To do this, I'll create a simple table called a mortgage amortization table. All that means is it's a table showing all the mortgage payments and interest charges over time on the loan. By the way, you can ask your mortgage lender for this for your mortgage.
How to Calculate Mortgage Interest (Build a Mortgage Amortization Table in Excel)
In this example, we'll assume a person takes out a 30-year fixed rate mortgage of $250,000 at a 7% interest rate. I put those numbers at the top left of the table that I'll be making.
For the table itself, I'll label the first row as month one and show the beginning principal balance of $250,000. Then I'll take the annual interest rate of 7% and divide it by 12 to get the monthly interest rate, since the normal payments are once per month, and then multiply that monthly interest rate times $250,000, since that is the outstanding amount of the loan in the first month. Each month, the bank will charge interest on the amount of the loan still outstanding.
In building this table, notice that I don't know yet how much the monthly payment will be. There's a formula to figure that out, but I'm not using it here, because I want you to see where the payment amount comes from. So in this table, we started the loan with the $250,000 balance, added interest to it for the first month, and didn't include a payment against the loan. We'll add that later, and therefore end the month with a balance of $1,458. Don't worry that it went up; that will get fixed once we know the payment amount.
For the second month, the beginning balance will be the same amount as the ending balance for month one. Again, add one month's interest charged on the loan balance and don't deduct a payment. Then I just repeat this process to create the whole table. The table will have 360 rows because the loan term is 360 months, which is 30 years.
Jumping ahead, here is the completed table. If we scroll down, you'll see all 360 rows. Now back at the top, you'll see I've left a spot here in green to add in the monthly payment, and just below it, in gray shading, is a box that says remaining 2,299,24. That number comes from the very bottom of the table and represents the remaining unpaid balance of the loan. That's a big number at the moment because we didn't yet apply any loan payments. If we scroll down again, you'll see the bottom right number in green.
Our plan now is to plug in different guesses at the amount of the monthly payment until we get that number to zero. When it's zero, we've found the required monthly mortgage payment to pay off the loan in exactly 360 months. So back at the top, we know the payment has to be at least the amount of the interest charged in the first month, because if we paid less than that, we would not be paying enough to pay off even the interest charge, and the balance on the mortgage would be going up, not down. By plugging in different numbers through trial and error, I find that the payment needs to be $1,663.126 to pay off the mortgage in exactly 30 years. So that's your mortgage payment.
Looking at the table, see that this column, D, shows the interest amount charged each month on this mortgage. In the first month, the interest charge was $1,458. Again, that comes from one twelfth of the annual interest rate of 7%, multiplied by the principal balance at the beginning of that month.
Looking at this small table to the right, notice that when the total monthly payment is $1,663, with interest for that month being $1,458 of it, the remaining portion of that monthly payment used to pay down the principal balance of the loan is only $25. Here in columns H and I, I show the principal amount that gets paid each month. Scrolling down, you can see that the principal portion of each payment is pretty small in the early years but gradually gets bigger as the loan balance gets paid down and the monthly interest charges get smaller.
Up here in yellow, see that if we add up all the monthly interest payments over the life of the loan, they add up to $300,048.75 in total. By the time you're done paying off this $250,000 mortgage, you will have paid almost $600,000.
How to Pay Off Your Mortgage Early (4 Strategies)
Okay, now let's talk about solutions. I'll discuss four examples of things you could do to reduce the amount of interest you'll pay and get the mortgage paid off faster. There are many variations of the same ideas, but these will illustrate it pretty well. These examples were done using a 7% mortgage, because the results will change based on the interest rate of the loan. I put together a table that I'll show after the discussion, showing these same four options using both a 4% interest rate mortgage and a 7% rate.
Here are the four examples.
Number one: make extra payments in addition to your normal loan payment each month. In this first example, I paid just an extra $100 per month towards the principal in addition to the normal monthly payment. The normal payment was $1,663, so I'm paying a total of $1,763. Just by paying an extra $100 a month, the 30-year mortgage got paid off in only 25.2 years. It was reduced by almost 5 years, and we saved $166,670 in interest that we did not pay but would have if we had stuck to the original mortgage schedule.
Remember, the reason for this is that the extra money we pay each month reduces the amount of principal remaining, which reduces the interest charges. The higher the interest rate on the loan, the more interest you can save by making early payments. With lower interest rate loans, even though the interest savings from making extra payments will be less, the loan can still get paid off a lot earlier. You'll see that when we get to the summary table in a few minutes.
Number two: here's another example of the power of increasing your monthly payment. This time, if we increase the extra payments to $250 a month, the mortgage will get paid off in just 20.6 years, shaving 9.4 years off the 30-year term and saving $126,200 in interest.
Number three: let's assume we're paying only the regular monthly payment, and in the 24th month maybe you get a bonus at work or just decide you have a little extra money available. If you put $5,000 into the mortgage just one time, with no other extra payments, you would save $28,730 in reduced interest charges over the life of the mortgage and shorten it to 28.3 years, a reduction of 1.7 years.
Number four: make biweekly payments. This means you divide your normal monthly mortgage payment by two and then pay that amount every two weeks. Because you're paying every two weeks, over the course of a year you will make 26 payments. Remember, this is 26 payments of half the mortgage payment amount, which is the same as making 13 payments of the whole mortgage amount. That's compared to making 12 payments per year normally, so you are in effect making one extra full mortgage payment each year. By doing this, you would pay off the mortgage in 23.7 years, shaving 6.3 years off the original and saving $86,500 in interest.
So what do all these examples have in common? They're all just different ways of making extra payments to the mortgage to reduce the cost of the mortgage and the time it takes to pay it off. You have to make extra payments to reduce the principal balance, which will reduce the remaining interest charges. Do that and start early, and you can save a lot of time and money on your mortgage.
Summary of 4 Mortgage Pay Off Strategies
Finally, here is the table showing the summary of these four examples for a 4% interest rate mortgage and a 7% interest rate mortgage. Feel free to pause the video to look at it. I'm not going to discuss it because it's pretty self-explanatory.
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