Wednesday, December 12, 2007

The joys of homeownership

It's probably best not to look at how little of my mortgage payments actually affect the principal on my loan. The payments on my second mortgage are $379.00 a month. Out of that, last month only $41.51 actually made its way to the principal. The credit union got the rest.



Larry said...

I'm going to share a little-known fact about mortgages with you and your readers. If you pay the principal portion before the month in which it is due, you avoid having to pay the interest portion of that month's payment.

You mentioned the example that your November (I assume?) payment was $41.51 principal and, by simple subtraction, $337.49 interest. How it works is like this: had you sent in the principal portion of December's payment, which would probably be $42 or $43 and change, on top of your November payment, you would get out of the $330-something of interest for December.

This is a trick my father learned about in the mid-1980s with the mortgage on my parents' house. From buying the house (in which they still live to this day) in 1978, up until roughly 1984 or so, he just paid exactly what was due every month. Then, he learned about how this works, and he had a 30-year mortgage which should have run through next year paid off by 1991.

It's especially effective for somebody who's at the point in the mortgage where you're at -- very early on, as ISTR you talking about buying the house only last year -- because the added principal amounts are so small and the avoided interest is so huge.

I know this is the case with my car loan as well, as I've contacted my bank to ask them about it. The difference is that it's not quite as advantageous on a car loan, because even at the outset, the payments are more than 60% principal and less than 40% interest.

Travis said...

Interesting. I've been consoling myself by remembering that I get a tax break on mortgage interest I pay, but not paying money is still better than paying it.

I have to say, though, if I'm understanding you correctly, I'm skeptical. If I did that each and every month, it would mean that I'd only have to pay interest once. For my next payment, I'd pay an extra $43 or so, and then after that I'd basically be out of paying interest forever, because I could always pay the next month's principal a month early. For under fifty bucks I'd save thousands every year. Something in me says "um, no."

So, what am I understanding incorrectly?

MntlChaos said...

If you pay the principal at the start of the month, then I think you end up saving one month off the _end_ of the loan.

The way a mortgage (or any fixed-term loan) works: each month you pay the interest on the existing balance (I'm not sure of when they determine the balance, or if it's an average daily balance thing, or whatever). Then the rest of the payment goes toward principal.

Thus if you make an extra payment of the principal payment at the same time as the previous payment, then the loan is in an equivalent state coming in to the month as it would have been going going in to the next month. Net result: from the point of view of the loan, you're one month ahead. If you keep making regular payments from that point on, then you'll finish off the loan 1 month earlier than usual.

Travis said...

Yeah, and that makes perfect sense. What doesn't make sense to me is this "Principle Pre-payment Technique" (PPT) thing that Larry is mentioning.

Travis said...

Okay, it seems that pretty much nobody calls it by that name, and also I misspelled principal. Here's the best thing I found on what I think Larry is talking about:

If I understand THAT article correctly, you're saving money because you're paying DOUBLE the principal each month. You reduce the total amount of interest you pay over the course of the loan because you paid more principal, effectively shortening the length of the loan—but it doesn't really reduce the amount of interest you pay each month. In that case, it would be just a method of accelerating loan payments, which I do plan on doing at some point in the not-distant future, at least for my more expensive second mortgage.

Jordan said...

Right, which works like how Yuliy described. In any case, it's something you should probably be doing if you can afford it, despite the tax deduction.

Travis said...

Well, versus doing nothing, paying off early is good. Versus high-yield investments, it can actually be advantageous to stay in debt. But, I'm risk-averse and not at all happy with being in debt, so I'll be paying things off more than making investments. The only investment I have planned is to redo my hideous kitchen.

Anonymous said...

Really, it's similar to taking your bonus once a year and using it to pay down your principal. You won't pay interest on the extra principal you paid down but you still have to pay everything else. It essentially just cuts the end of your loan shorter. There are a few key things to remember here though when thinking of doing this:
1. Your interest is a write-off (so you are really only responsibile for 70% of your interest payments and the government effectly covers the rest).
2. You are still gaining the appreciation on the value of your home regardless of whether you pay more or less.
3. If you can put your money in another investment, it will likely make more than you're paying in interest.

Say you're interest rate is 6%. You're essentially pnly paying around 4%. If you invest in a standard mutual fund, you'll likely make 0-15% in any given year. I'd argue that the upside is worth the risk and my financial advisor says the same thing. I specifically asked him this question and he says it's almost always better to invest as long as you diversify to reduce your risk.