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Matters of Principal

Jonathan Clements

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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