Was just reading an article here and seems confusing: Making extra mortgage payments? Not so fast
I was trying to figure out the reasoning behind some of their bullet points in 1 and 2. Maybe I’m just missing something and someone can explain to me.
For example, assume you have a 30-year mortgage with a monthly payment of $2,000. Your first payment includes about $360 in principal and $1,640 in interest, while the last payment includes about $60 in interest and $1,940 in principal. If you made a double payment of $4,000 (to “save” on interest), all you’re saving is $60, and that’s 30 years from now. Put another way, it’s a return of less than 0.1% per year.
Wouldn’t your overall interest decrease per month from the slightly lower principal amount as well so it’s not really just $60?
For example, suppose you have a 30-year loan of $419,000 at 4% interest. Your standard monthly payment of principal plus interest would be $2,005. If you paid an extra $2,000 per month, you’d save almost $204,000 in interest and pay the loan off in under 11 years, shaving about 19 years off your payment schedule. Sounds pretty good, right? Not so fast. It might not be the best use of your money. Here’s why:
Suppose instead of making extra payments, you deposited the $2,000 per month in an account earning that same 4% per year. You would have contributed a total $720,000 plus earned $679,000 on that sum, for a grand total of nearly $1.4 million. Since you didn’t pay off the mortgage early, you would still pay around $300,000 in interest over the course of 30 years, but you would end up $379,000 ahead. That handily beats the $204,000 you would have saved by prepaying the mortgage.
If you ignore the tax implications and assume that you could have a 4% savings account, why is there a difference?