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HAVE YOU EVER HAD one of those debates where you come up with the winning argument—hours later, long after everybody has gone home?
Among the many financial topics that cause confusion, extra-principal payments on a mortgage deserve a special mention. For decades, I feel like I’ve been trying to stamp out the nonsense that’s spouted on this topic, and I think I finally have the answer. Maybe.
The chief reason for all the confusion is a mortgage’s shifting mix of principal and interest. Most of each monthly payment goes toward interest early in a mortgage’s life, with more getting put toward reducing the loan’s principal balance as time goes on. Adding to the confusion: What happens if you make extra-principal payments on a fixed-rate mortgage is different from what happens with an adjustable-rate loan.
With a fixed-rate mortgage, extra-principal payments shorten a mortgage’s length. With an adjustable-rate mortgage, or ARM, extra-principal payments don’t affect the loan’s length. Instead, they trim the required monthly payment when the loan next adjusts. At that point, the ARM’s required monthly payment shrinks based on the reduced principal, though this reduction could be partly or entirely offset if there’s an increase in the ARM’s adjustable rate.
Unlike in other countries, most U.S. homeowners take out fixed-rate mortgages. Some of these fixed-rate borrowers look at the hefty amounts of interest charged each month in the early years and the relatively modest amount of interest charged later on, and declare that it’s only worth making extra-principal payments during a mortgage’s early years. This notion has some validity—but the reasoning is faulty.
Other folks take this muddled thinking one step further. They look at the hefty amount of interest charged in the early years, coupled with the fact that extra payments on a fixed-rate mortgage reduce the loan’s length. They then calculate extraordinary returns from making extra-payments in the early years—because they assume they can somehow avoid the interest charged in the months that immediately follow.
What’s wrong with these contentions? For starters, it’s important to distinguish between the percentage interest rate charged and the dollar amount of interest incurred. On a fixed-rate mortgage, the interest rate is—surprise, surprise—fixed. Unless you refinance, that percentage interest rate won’t change, so the rate you’re charged is the same in a mortgage’s 29th year as it is in the first year.
By contrast, the dollar amount of interest charged does indeed dwindle as a loan’s principal balance shrinks. Mortgage repayment—or “amortization”—schedules are set so that, with each payment, you not only pay the interest owed but also reduce the principal, with the goal of paying off the loan after, say, 15 or 30 years. As your principal shrinks, so too does the dollar amount of interest you’re charged each month.
That brings us to the shrinking loan length that results from extra-principal payments on a fixed-rate mortgage. Here’s where folks often get confused: The monthly payments you miss aren’t the upcoming ones, but rather those at the end of the loan. Don’t believe me? If you want to live dangerously, go ahead and make a big extra-principal payment, and then try to skip the next few monthly loan payments.
Yes, you guessed it: Soon enough, the mortgage lender will be threatening to foreclose. Your extra-principal payments may have shortened your loan’s length, but that doesn’t mean you can start skipping payments.
Even though the payments you miss by making extra-principal payments are those at the end of your mortgage, it’s still worth making those extra-principal payments, especially early in a loan’s life. But the reason isn’t because those extra-principal payments earn some extraordinarily high annual return or allow you to skip upcoming payments.
Rather, making extra-principal payments early on is worthwhile for the same reason it’s worth investing when we’re young: compounding. Whether you make a $1,000 extra-principal payment in the first year of a 5% mortgage, or the 10th year or the 20th, your $1,000 effectively earns 5% a year. But if you make that $1,000 extra-principal payment in the first year, you’ll earn 5% a year for far longer—and the result is you’ll shorten your mortgage’s loan length by significantly more.
Let’s say you make a $1,000 extra-principal payment on a $200,000 30-year mortgage charging 5%, with its $1,074 monthly payment. If you do that in the first month of the mortgage, you’ll avoid four-plus monthly payments at the end of the loan, according to Calculator.net’s amortization calculator. That works out to $4,420 in avoided mortgage payments. In other words, your $1,000 buys you $4,420 in financial relief 30 years later, which—if you do the math—is equal to an annualized return of some 5%.
What if you make that $1,000 extra-mortgage payment when there’s five years left on your mortgage? You’ll avoid one loan payment at the end of the mortgage, plus part of the prior one, for a total payment savings of $1,277. Do the math, and that’s also equal to a 5% annualized return—but the cumulative gain doesn’t amount to as much because there’s less time for compounding to work its magic.
The bottom line: Making extra-principal payments early in a mortgage can indeed be a good strategy—because those payments will reduce your loan’s length by far more than the same amount of extra-principal paid later on. But it isn’t because of some convoluted reasoning involving the dollar amount of interest charged in those early years. Rather, the value of those early extra-principal payments lies in the power of compounding over many, many years.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X @ClementsMoney and on Facebook, and check out his earlier articles.
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My wife and I agreed we wanted no mortgage when I retired. So I used a mortgage loan calculator to figure out how much I would have to pay to make our 20 year loan an 11 year loan.
we just paid that amount every month and retired the loan just before I retired.
i only experienced one problem with this approach. Some online credit/identity protocols ask you how much your mortgage payment is in order to verify your identity. I had a hard time remembering our payment amount since I always paid about $500 more 😂
The flaw in your argument is that you treat nominal dollars as equivalent to real dollars.
How would that alter the analysis? If you changed the 5% annual nominal return on prepaying a fixed-rate mortgage to, say, a 2% real return, you’d still get the same result — that the gain from paying down a fixed-rate mortgage is a shorter loan length, with a greater reduction in loan length resulting from prepayments made earlier on.
Thanks for explaining this, Jonathan. I am glad that I’ve been making extra principal payment for the last several years, and will continue to do so.
I have read arguments, pro and con, on this subject for years and the answer always depends on a variety of factors: loan type, loan interest rate, returns available in other investments, time, can you afford it and – my personal favorite – how you feel about debt. In my case, my wife and I agreed early on in our marriage that we would always pay extra on our mortgage in order to be debt free as soon as possible. It took several houses, re-fi’s and time in order to finally pay off our home mortgage, but we managed to achieve our goal at about the same time we retired. Would we have been better off to have to have invested these moneys in the stock market over the years? Hard to say, but what I do know is that we have a peace of mind of not owing money to anyone that made the effort worthwhile.
I did early principal payments for several years after the mortgage began. When I retired, I stopped making the extra principal payments and just paid the regular monthly payments which have been ongoing since inception. I have delayed taking SS but that will soon change and the extra principal payments will resume. I am looking forward to the financial freedom when the house is finally paid off.
Making extra principal payments is essentially the same as buying illiquid zero coupon bonds that mature in the month that the loan finishes amortizing. When I have made extra payments, I have compared to the rate I could get with zero coupon Treasuries. When the rate on the latter was high, I started building a ladder that would have covered the payments at the end of the amortization period.
Thank Jonathan,
In 2022 I bought a home at age 70. I have the income to pay a double payment and it’s going very well. My goal is to have it paid off by 2031. Paid for properties make a great inheritance for the kiddos.
We can not take it with us, but we can pass it on it seems!
We bought our current home in 2019 and refinanced our mortgage in 2020 to 3.125%. So we’re fairly early into our mortgage. We’ve made a few principal extra payments, but since interest rates have gone up on savings accounts, it’s hard to convince ourselves to do it. When savings rates go down again—and they will at some point—then maybe we start prepaying again.
Hi Jonathan,
After reading your article I have a question. Say someone has a 3-4% mortgage. How does the decreased value of future dollars due to inflation, and the historical returns of the markets especially as it relates to young adults (they being invested primarily in equities) affect your calculus?
The article doesn’t address the topic of whether extra-principal payments are a good financial move. That will indeed depend on both the investment alternatives and your mindset. I paid off my 7%-plus mortgage through the 1990s and early 2000s because the return I earned was better than bonds and, in fact, I didn’t bother owning any bonds at all. Today, if I had a 3% mortgage, I’d probably invest my spare cash. But others — who like the notion of being debt-free — might still make extra-principal payments, even if it isn’t the financially optimal thing to do.
Hindsight, I should’ve invested the extra in well-chosen stocks. That opportunity cost is only noticed when looking in the rearview mirror years later. Not having a crystal ball, making extra principal payments still helped get rid of the mortgage faster.
Dating myself…my first mortgage was 10%! That wasn’t good but at least my payments due kept dropping over the years, as the rates declined.
My financial intuition told me it was a good idea to do this when I bought my first home back in 1988. Thanks to this excellent explanation, now I know why! Thanks, Jonathan for another excellent article!
Thanks for the clear and enlightening explanation of the impact of making extra principal payments. However, I’m not sure I would agree that making the payments early in a mortgage is necessarily “better” than making them later in a mortgage – it just has a greater reduction in your remaining payments. I think determining whether it is a “good strategy” is solely based on the alternative use you can make of that extra cash. If you have extra cash at your disposal early in your mortgage’s life and you invest it, you also get the benefit of compounding.
I think the implied understanding was that making payments early in a mortgage is “better” than making them later IF one were considering among only those 2 options and all others things being equal.
I wish this article had appeared 10 years ago when I first bought my home. But as Dick mentioned, I was not in a great position to make extra principal payments–although even small payments would have been beneficial. What you still hear is people decrying the loss of mortgage interest to write off on your taxes, which weighed against the overall interest you save I don’t understand.
It makes even less sense these days when the vast majority of folks don’t have enough deductions to justify itemizing!
Always a good article! Like so much in life, the issue of “It depends” pertains to the topic. If the money market is 0.07% (or other investment alternatives are not desirable) and the unpaid mortgage rate is 7% that is quite different than the money market is 12% (I’m dating myself!) and the unpaid mortgage is 8% (there was a time when people would dance in the street for 7% mortgages!).
So many financial discussions seem to need the “It depends” on the particular unique situation of the individual and the circumstances. And, as I grow older, more of life seems to be that way too!
After building my first house in1990, the best rate available was 10% for 15 years. In the following years, the rates dropped significantly and I refinanced twice (in house at a credit union) plowing those savings into extra principal payments and we paid the house off in 7 years. That financial freedom enabled us to save plenty and to do three home upgrades over the following ten years plus purchase a second home for our daughter to live while at a state university because of a shortage of dormitory space.
It also depends on how much you value not having a mortgage payment, which is not going to appear in a spreadsheet.
Good article. The only thing I’d add is early in my career I had a discussion on this topic with a co-worker and it took a few minutes to figure out that what he was doing was pre-paying future payments on his fixed rate mortgage. His logic was that he was simply pre-paying his mortgage 6 months ahead so if he went through a layoff he’d have some time to find other work. Sure enough, about 18 months later we were laid off due to an economic slowdown, so he actually benefited from this technique. I guess that’s not a bad variation of an emergency fund if you’re concerned about your ability to keep cash in an emergency fund and not spend it. The only reason I mention this is that back then it took a couple minutes to figure out that what he was doing was completely different from what I was describing, and was yet another twist on the “making extra house payments” idea.
One more factor which isn’t mentioned in this very good article is the effect of inflation on the balance of the loan over time. As your income rises with inflationary adjustments, the loan balance does not adjust. The higher inflation is, the more advantage over 30 years in not prepaying principal. In a 5% inflation world, someone with a 30 year loan at 3% has a 2% negative real interest rate.
Nice explanation! I bought my last house with a 30 year fixed mortgage at 10.5% (it was 1989) with a two-year builder buy down. I refinanced for 15 years at 7.75% when the buy down expired. Between the refi and monthly extra principal payments for several of the early years I paid it off in a little under 12 years. And I definitely tracked the effect of those extra payments. True, I got a smaller tax deduction as the interest payments got smaller, but then I lived in the house for another twenty-plus years with no mortgage payment.
(Note to Dick – buying less house than I could theoretically afford and then having no mortgage payment contributed to my ability to retire on less than 100% of my income.)
Great article, Jonathan. I also suffer from lying in bed thinking about arcane things like amortization schedules. This is a great explanation. Early in my career I heard a version of this from a colleague. he had just bought his first house, and his mortgage person told him to “think months”. If he could pay a little extra principal each month, equal to the next month’s principal amount, it would cut months off the loan term and compound. 40 years ago houses were less than $100K and the extra principal was small, so he could afford it.
Good explanation JC, and I didn’t know those facts regarding ARMs.
This comment is slightly off topic, but one of the most common mistakes I see is when a homeowner refinances a mortgage with another mortgage of the same length. Even if they reduce their payment with a better interest rate they still end up paying more interest over the length of the loan, not to mention the additional closing costs.
Folks forget that if, say, they’re seven years into a 30-year mortgage and they refinance with another 30-year mortgage, they’ll end up with a lower payment even if the interest rate is the same — simply because they’re extending the loan repayment over an additional seven years. There’s an illusion here that many folks overlook — and it’s why I encourage those who refinance to get a new mortgage that’s similar in length to their current loan’s remaining years, and preferably shorter.
This is what we did during the 1998 Russia debt crisis. I read in the paper about the crisis and that investors were fleeing to the safety of US Treasuries. I also knew mortgage rate were affected by Treasury rates. At the time we were five years into voluntarily making biweekly payments on a thirty year mortgage. We refinanced to a fifteen year mortgage costing an extra $100 per month and stopped making biweekly payments.
Hi Jonathan, this is Chris. Really good article. I can concur with you and Kevin about how fast the number of payments go down when you make a principal payment at the beginning of your mortgage. We did also. My spouse made an amortization schedule that you could interact with and I found it very motivating to see the principal balance and #of payments go down when I made the extra payments. Would definitely recommend folks doing this.
I also wanted to give a little tip when buying. Usually your first month’s mortgage is not due for a month b/c interest is paid in arrears, but you have been paying rent anyway. Use that $$ to make a principal payment on your new mortgage.
My other tip is for when you buy your second or subsequent home. If you have been escrowing your taxes/insurance for the first home with your bank, you might receive a check for what is remaining in escrow when you sell it. We did a few times. I used that $$ to make an extra principal payment also.
Monthly payments to mtg principal is a great strategy that no no bank official will ever mention. Great Article
The logic is there, but I’m guessing in the early years of a mortgage the cash for extra payments isn’t for most people.
Jonathan, as I clicked on Humble Dollar this morning (unique to see your name on a Friday morning article!), I just so happened to be penning an email containing thoughts I wished I’d expressed in a difficult conversation at work yesterday–which only occurred to me at 3:30am this morning, waking me from my sleep. So yes, I know what you mean about coming up with the “winning argument” after the fact!
Regarding your article, what an excellent explanation you provided. It is so very clear to me now, and your recurring 5% example toward the end perfectly illustrated the point. Thanks!
I was not super aggressive making extra payments on our house in the early years of our fixed rate mortgage; just an occasional extra from time to time. Then about 12 years in I realized I hated having that monthly payment hanging over my head and became laser focused on ridding myself of that burden; I became fanatical and paid it off before we hit the start of year year 15. Since it was a 30 year fixed mortgage it was amazing how the months at the end disappeared from my Excel amortization table with each extra payment to principal. In the end I saved over $130,000 in interest payments. If only I had been paying attention at the beginning, instead of just paying interest! 😉
“HAVE YOU EVER HAD one of those debates where you come up with the winning argument—hours later, long after everybody has gone home?”
Let’s just change this to “… long after my wife has gone to bed”. Happens to me all the time on every argument with her.