Why Your Mortgage Balance Barely Moves and What One Extra Payment Can Do?
Coffee Shop: Plain Legal Talk
TERM | PLAIN ENGLISH DEFINITION | WHY IT MATTERS |
Principal | The amount you borrow | Interest is calculated using the principal still owed |
Interest Rate | The percentage charged for borrowing the money | A high rate increases the payment and total interest |
APR | A broader measure of borrowing cost that includes the interest rate and certain loan changes | Useful when comparing loan offers |
Loan Term | The time allowed to repay the loan, commonly 15 or 30 years | A longer term usually lowers the payment but increases the total interest |
Amortization | The schedule dividing payments between principal and interest | Explains why the balance decreases slowly at first |
Principal and Interest Payment | The portion of the payment that repays the loan | This is not necessarily the total monthly payment |
Escrow | Money collected for expenses such as taxes and insurance | Escrow changes can cause the total payment to increase |
Mortgage Insurance | Insurance that generally protects the lender if the borrower defaults | Adds to the monthly cost but does not reduce principal |
Prepayment Penalty | A charge that may apply if the loan is paid early under specified circumstances | Should be checked before making large principal payments or refinancing |
Balloon Payment | A large balance due at the end of certain loans. This usually requires a re-finance at the end of the original loan term | The loan may not be fully paid through ordinary monthly payments and may require the borrower to refinance a large balance at the end of the original loan term |
Adjustable Rate | An interest rate that may change after an initial period | Future payments pay increase if the interest rate increases |
You buy a house, faithfully make twelve mortgage payments and then look at your balance expecting to see real progress.
Instead, the balance has barely moved.
That can feel like something has gone wrong, but it is usually the result of amortization—the method used to divide each mortgage payment between principal and interest over the life of the loan.
Once you understand how amortization works, you can also understand why even a relatively small extra payment toward principal may save you thousands of dollars and shorten the life of your mortgage.
WHAT ARE YOU ACTUALLY PAYING EACH MONTH?
Your total mortgage payment may include several different expenses:
Principal: The amount you borrowed to purchase the property.
Interest: The amount the lender charges for allowing you to use its money.
Property taxes: Often collected monthly and held in an escrow account until the tax bill is due.
Homeowners insurance: Also commonly collected through escrow.
Mortgage insurance: This may apply depending upon the type of loan and the amount of your down payment.
Only the portion applied to principal actually reduces the amount you borrowed.
Payments for taxes and insurance are expenses associated with owning and protecting the property. They do not reduce your loan balance. Interest is the cost of borrowing the money, so it does not reduce the principal balance either.
WHAT DOES “AMORTIZATION” MEAN?
Amortization is simply the process of paying off a loan through scheduled payments over a set period of time.
With a typical 30-year fixed-rate mortgage, the monthly principal-and-interest payment generally remains the same. What changes is how that payment is divided.
Early in the loan, the outstanding balance is still high. Because interest is calculated using that balance, a larger portion of each payment goes toward interest and a smaller portion reaches principal.
As the principal balance gradually decreases, the amount of interest due also decreases. More of each later payment can then be applied to principal.
This does not mean that the lender simply collects “all the interest first.” Interest is calculated throughout the loan. The problem is that, during the early years, it is being calculated against the largest balance you will ever owe.
A REALISTIC EXAMPLE
Assume a buyer borrows $300,000 with a 30-year fixed interest rate of 6.5 percent.
The monthly principal-and-interest payment would be approximately $1,896.20. That figure does not include property taxes, homeowners insurance, mortgage insurance or other possible expenses.
For the first payment, approximately $1,625 would go toward interest.
Only about $271 would reduce the principal.
After making twelve principal-and-interest payments totaling approximately $22,754, the borrower would still owe about $296,647.
In other words, the borrower paid more than $22,000 during the first year, but the principal balance decreased by only about $3,353.
That is amortization at work.
The payment is doing exactly what the loan documents say it will do. Unfortunately, many buyers sign those documents without anyone ever plainly explaining what the numbers will look like during the first several years.
WHAT CAN ONE EXTRA PAYMENT DO?
Now assume that the same borrower makes one additional principal-and-interest payment of approximately $1,896 every year and instructs the mortgage servicer to apply it directly to principal.
Under this example, the borrower could pay off the mortgage approximately five years and eight months early and save roughly $84,000 in interest.
The exact savings will depend upon the loan balance, interest rate, payment date, remaining loan term and how the mortgage servicer applies the additional money. But the principle remains the same: reducing principal earlier means less money remains subject to interest in the future.
The borrower does not necessarily have to produce one large extra payment at the end of the year.
In this example, dividing that additional payment by twelve would equal approximately $158 per month. Adding that amount to each monthly payment—and ensuring that it is applied to principal—could produce a similar or even slightly greater benefit because the principal is being reduced earlier throughout the year.
The borrower may also use tax refunds, bonuses or other occasional income to make principal reductions without committing to a larger payment every month.
THE IMPORTANT WORDS ARE “APPLY IT TO PRINCIPAL”
Sending extra money does not always guarantee that it will be handled the way you intended.
Depending upon the mortgage servicer and its payment system, additional money could potentially be credited toward a future payment rather than immediately applied to principal.
Before making extra payments, contact the servicer and ask:
1. Does my loan permit additional principal payments?
2. Is there any prepayment penalty?
3. How must I designate an additional payment so that it is applied directly to principal?
4. Will the additional payment advance my next due date, or will it immediately reduce my principal balance?
5. Where will the principal reduction appear on my next mortgage statement?
Then check the next statement to confirm that the payment was applied correctly.
Small, periodic principal payments do not ordinarily trigger a prepayment penalty, but borrowers should never assume. Review the promissory note, mortgage documents and information provided by the loan servicer.
DOES AN EXTRA PRINCIPAL PAYMENT LOWER YOUR REQUIRED MONTHLY PAYMENT?
Usually, no.
An additional principal payment generally reduces the outstanding balance and may shorten the time required to repay the loan, but it does not ordinarily change the required monthly principal-and-interest payment.
Some lenders may permit a mortgage “recast” after a substantial principal reduction. With a recast, the lender recalculates the monthly payment based upon the lower balance and remaining loan term. A recast is different from refinancing, and not every loan qualifies.
Without a recast or refinance, the borrower generally continues making the same required payment while reaching the payoff date sooner.
DO NOT SEND EXTRA MONEY IF IT CREATES A NEW FINANCIAL EMERGENCY
Paying additional principal can be a powerful financial tool, but it is not the correct first move for everyone.
A homeowner should not drain an emergency fund or fall behind on higher-interest obligations simply to make an extra mortgage payment. Money applied to a mortgage is converted into home equity and may not be easily available when an unexpected expense occurs.
The better decision depends upon the homeowner’s complete financial circumstances, including other debts, savings, interest rates and the specific terms of the mortgage.
READ THE NUMBERS BEFORE AND AFTER CLOSING
Before signing a mortgage, review the projected total of payments and finance charge shown in the loan disclosures. Do not focus only on whether the monthly payment fits the current budget.
Ask how much of the first payment will be applied to principal. Ask for an amortization schedule. Look at the estimated balance after five, ten and fifteen years.
After closing, continue reviewing the monthly statements. Confirm the outstanding principal balance, interest rate, escrow activity and the application of any additional payment.
A mortgage may be the largest financial obligation a person ever signs. Understanding how it works should not require a finance degree.
The shortest explanation is this:
Interest is calculated using the amount you still owe.
Early in the loan, you owe the most, so you pay the most interest.
When you reduce principal early, you reduce the balance against which future interest is calculated.
That is why one extra payment may be worth far more than the amount written on the check.
This article provides general educational information and is not individualized legal, tax or financial advice. Mortgage terms vary. Borrowers should review their loan documents and consult their lender, mortgage servicer or appropriate professional before making financial decisions.
We also have self-service real estate forms, drafted by Judith L. Hampton, licensed Louisiana Attorney, available for purchase and download. Purchase and download the document you need from our website - fill in your information - print and complete yourself without paying attorney fees. (Recommended for simple matters only for individuals who have knowledge of what they need. If you are not sure of what you need or how to complete it, we suggest calling or texting our office for legal guidance 318-368-7444 or click to start your real estate intake below). You can shop our self-service real estate forms here:
Judith L. Hampton
Attorney-at-Law
Hampton Law Firm
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