Should you pay down your mortgage? We get that question a lot.
Everywhere you look it seems financial experts tell you this a good idea. In most cases, that’s a TERRIBLE idea and will negatively impact your financial future.
The first step to understanding why is to look under the hood of your mortgage. Here’s how your mortgage works.
You borrow $1M from the bank to buy your house. You get a 30-year fixed-rate mortgage at 4%.
At the time you take out your mortgage, your monthly payment is calculated and locked in. It’s a simple Time Value of Money calculation.
So your 30-year, 4%, $1M mortgage would equal a monthly payment of $4774. But wait….
With each monthly payment, a little goes to the principal and a little goes to the interest.
The amount of your mortgage payment that goes towards interest is recalculated every month. It’s based on the remaining balance of your mortgage multiplied by your mortgage rate divided by 12 (as in months).
So out of your very first $4774 mortgage payment, $3,333 goes towards interest. ($1,000,000 x 4% / 12 months). And the remaining $1441 pays down your principal.
After paying $1441 towards your mortgage balance, your interest for next month is then recalculated… $998,559 x 4% / 12 months = $3328 interest.
Since the interest portion is smaller, a larger part of your $4774 payment goes towards the principal ($1446 compared to $1441 the first month).
That’s why you hear about how most of your mortgage payments go towards the interest in the beginning.
Anything extra you pay all goes towards the principal.
So in our example, if you pay $1,000 extra this month, you’ll pay $3.30 less next month in interest. Which is to say $3.30 MORE will go towards your principal.
If you regularly make extra payments, you’ll accelerate your principal paydown, pay off your mortgage sooner, and pay less in interest.
Looks like a good thing on paper. But looks can be deceiving.
Find out why paying off your mortgage sooner and paying less interest is a bad thing next week…