Principal vs. Interest

MOST MORTGAGES are designed so that, with each payment, you not only pay the interest owed on the outstanding loan balance, but also you pay down part of the loan’s principal balance. That means that, in the following month, the principal is slightly smaller, so you owe less interest and even more of your monthly payment can go toward reducing the loan balance.

As time goes on, the amount earmarked for principal starts growing by leaps and bounds. Suppose you borrowed $300,000 through a 30-year fixed-rate mortgage costing 5%. Assuming you didn’t make any extra principal payments, it would take 15½ years to pay back the first $100,000 and another 8½ years to pay off the next $100,000. What about the final $100,000? That’s paid off in the mortgage’s last six years because, by then, most of your monthly payment is going toward principal and not interest.

This shifting mix of principal and interest often creates confusion among mortgage borrowers. One misconception: It isn’t worth making extra principal payments when a mortgage is close to being paid off because, at that point, you aren’t getting charged much in total interest.

That’s true—except you are still getting charged the same interest rate. Suppose you have a fixed-rate mortgage costing 5%. Whether you make an extra principal payment in year one or year 30, the annual pretax return is still the same 5%. The only difference is that the extra principal payment early in the life of a mortgage saves you 5% in annual interest for more years.

Next: Prepaying Mortgages

Previous: Home Equity Loans

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