How to Reduce the Mortgage Term
Larger Mortgage Payments Can Save Thousands of Dollars
© John Wu
Jun 5, 2009
Extra payments on a mortgage bring down the balance owed. During the first decade of a 30-year mortgage, a small increase in just one month's payment may be enough to reduce the term of the mortgage by one month.
Monthly Payment Amount Going to Principal
The first step to shortening the mortgage term is to find out how much of this month's payment goes to principal. An amortization calculator such as this one at Bankrate shows how much each payment goes toward principal. The portion of the monthly mortgage payment going towards escrow for property taxes and insurance should not be included in the monthly payment.
Best to Reduce the Mortgage Term Early
During the beginning of a 30-year mortgage with a 6% fixed interest rate, less than 20% of each month's mortgage payment goes to principal. If an extra payment totaling just 20% of the monthly payment is made at the beginning, which will be enough to shorten a 30-year mortgage by one month. If the 20% extra payment is paid every single month, a 30-year mortgage's term will be reduced by nine years.
Not as Good Near The Mortgage Payoff
When there is not much time left on the mortgage, a substantial portion of the monthly payment goes to principal. During the 25th year of a 30-year mortgage with a 6% fixed interest rate, around 80% of the monthly payment goes to principal. In order to reduce the mortgage term by just one month, an extra payment totaling 80% of the monthly payment is needed. That is a lot more than the 20% extra payment needed during the first month of the mortgage.
The Bi-Weekly Payment Plan
Banks sometimes offer borrowers to change an existing 30-year mortgage monthly payment plan to a bi-weekly payment plan. The effect of making half of the monthly payment every two weeks results in making 13 months worth of payments (26 bi-weekly payments per year) in 12 months. A 30-year mortgage term will be reduced to just over 23 years.
The disadvantage of the bi-weekly payment plan is that banks will not change the payment plan for free. There is always a sizable fee for changing the payment plan. Also, there is no interest rate reduction for reducing the 30-year mortgage term to a 23-year mortgage term with a bi-weekly payment plan even though that means less credit risk for the bank. In a May 24, 2009 New York Times article entitled "More Takers for 15-Year Loans" Bob Tedechi explains that those who choose a 15-year mortgage instead of a 30-year mortgage typically save around 0.3% on the interest rate.
If the choice is between a 30-year mortgage with a bi-weekly payment plan and a 15-year mortgage, choose the 15-year mortgage for the interest rate reduction. Because of the closing costs to refinance, it may be advantageous to choose a bi-weekly payment plan if the house already has a 30-year mortgage.
Owning a Home Free and Clear
In these challenging economic times, owning a home in the free and clear of any mortgage brings an incredible amount of security. Shortening the mortgage term by making larger monthly payments brings the end of the mortgage a lot sooner than the typical 30 years no matter which method is used.
Readers interested in this topic may also want to read about the consequences of late mortgage payments.
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