| Gary Foreman is a former Certified Financial Planner (CFP) who currently writes
about family finances and edits
The Dollar Stretcher website
http://www.stretcher.com. You'll find hundreds of FREE
articles to stretch your day and your budget! |
Dear
Dollar Stretcher,
I once heard that you can cut a mortgage in half by simply making
one extra payment per year. Is this true? And does this work with
any loans like... car, personal and student loans? Thanks.
--Tanya P.
Like many of us, Tanya would like to
get the mortgage paid off in something less than 30 years. And,
she's willing to pay a little more than promised to accomplish that
goal. So let's see whether one extra payment a year is enough to get
the job done.
Tanya does have the right idea.
Especially in the early years of a mortgage. Her monthly checks
repay very little of the principal at first. It will be years before
she's made much of a dent in the amount owed on the mortgage.
Let's take a standard 30 year, 8%
mortgage. At the end of the first year, Tanya will still owe $991.65
for every $1,000 she borrowed. She will have written checks for
$88.08 and only reduced the principal by $8.35. So for the first year
for every dollar that she paid, less than one thin dime went to
repay the amount she owed.
 So Tanya's strategy is a good one.
Put more of each payment to work reducing principal because there's
less interest owed.
But unfortunately she won't be able
to cut her mortgage term in half with one extra payment per year. At
least not at today's interest rates. In fact rates would have to be
17% for that to happen. But that doesn't mean that it's still not a
valuable tool for Tanya to consider.
One extra payment per year on an 8%
mortgage would move her payoff on a 30 year mortgage up seven years.
Not a shabby reduction.
An alternative would be to add 1/12th
of a payment to each monthly check. That would spread out the extra
payment over the year. Doing that would pay off the mortgage a
couple of months sooner than the extra annual payment.
So one extra payment wouldn't cut the
mortgage in half, but it would cut about 25% off of the term.
What about other debts? The idea is
the same. Paying additional principal means that more of each future
payment is reducing even more debt rather than just paying the
interest owed.
One major difference. The longer the
life of the loan the bigger the effect of any prepayments. Paying
extra principal on a 30 year mortgage makes a big difference. The
difference on a 3 or 4 year auto loan isn't so significant.
For comparison, we're going to assume
an 8% 48 month car loan. For every $1,000 borrowed the monthly
payment would be $24.41. The payment is higher than for the mortgage
because the $1,000 that was borrowed is being repaid over a much
shorter period of time.
For instance, in the first month that
$24.41 payment actually reduces the amount owed by $17.75. But
adding one extra payment per year will only pay off the loan 3
months early. So paying extra principal on an auto loan won't make a
huge difference.
But that doesn't mean that the
strategy only works for mortgages. Credit card debts are another
fine candidate for extra payments. Most credit cards are designed to
keep you in debt forever.
 Many payments are as low as 1.5% of
the amount owed. That means that you'll be paying only $15 per
$1,000 owed. And if your interest rate is 15% (a typical rate)
you'll be paying off that debt for 133 months or over 11 years. Even
if you don't charge another cent or trigger any fees on the account.
Doubling the $15 minimum payment to
$30 would cause the loan to be repaid in just 43 months. A big
difference.
So Tanya's on the right track. Paying
extra can make a difference. To get the biggest bang for her buck
she should use extra money to pay off loans that run for many years
like mortgages. Or ones that carry a high rate of interest like
credit cards.
--End--
| 
