How to pay off mortgage earlier and pay less interest to a bank?
In this post, we will see discuss the mortgage components and how you can pay off the mortgage earlier using the different levers the mortgage gives you. Also, we will discuss whether more frequent mortgage payments impact mortgage terms and the money you end up paying in interest. What has an even greater impact on paying your mortgage off earlier?
It is common knowledge that through the life of a mortgage you pay over half of the price of your property in interest. For example, for a $300,000 mortgage with 3% interest and a 30-year amortization period, you will pay $155,000 in interest. If your interest rate is 4%, the total interest payments increase to $215,600. Obviously, nobody likes to pay this much in interest, as this money could be feeding your retirement bank account or other investments. The goal of this post is to show the factors that can help you pay off your mortgage earlier and pay less interest to the bank.
Before we jump into discussing how you can pay less in interest and pay off your mortgage earlier, let's cover the basics of how a mortgage works.
There are 3 key factors that impact the length and the amount of mortgage.
The amount of your mortgage.
Interest rate.
Mortgage amortization period.
The amount of your mortgage is calculated as:
Mortgage amount = property price - downpayment
The 3 key factors above impact the 2 outcome metrics:
Amount of minimum monthly payment.
Amount of total interest you will pay to a bank over the course of the mortgage.
Before we jump into discussing the relationship between the 3 key factors and the 2 outcomes and how they can be manipulated to reduce the mortgage term and interest we have to cover the key mortgage concepts:
First, a mortgage is a very large amount of money to borrow. Hence, you have to pay it off over the course of 15 to 30 years.
Second, every month the amount you borrowed accumulates interest you have to pay for borrowing the money.
To illustrate, let's say you borrowed $300,000 (face value of a mortgage) at a 3% interest rate. Your debt accumulates interest monthly. This means that every month you would need to pay:
$300,000 * 3% / 12 months = $750 in interest.
In addition, you would want to eventually pay off your mortgage, so you also have to pay off a portion of your $300,000 loan every month. Thus, your mortgage monthly payment consists of interest and a tiny portion of the loan. When you apply for a mortgage and set the desired amortization period of a mortgage (let's say 30 years or 360 months) the bank calculates the required monthly payment to fully pay off the loan by the end of the mortgage term.
The good thing is that with time, as you pay off the loan (face value of the mortgage) you are paying less in interest and more towards your loan. As you can see below, for the first month's payment, less than half goes against your mortgage balance. However, over time, as the balance of your mortgage decreases, you pay less interest each month.
| Month 1 payment | Month 120 payment | Month 240 payment |
Monthly payment | $1,264.81 | $1,264.81 | $1,264.81 |
Interest | $750 | $571.88 | $329.80 |
Principal (amount to pay off your loan) | $514.81 | $692.93 | $935 |
Mortgage balance | $299,485.19 | $228,059.72 | $130,986.84 |
With that, as you can see below, the interest you pay every month decreases, payments against your mortgage accelerate and you pay off your mortgage faster the closer you get to the end of the amortization period.
Now that we have covered the basics of how mortgage works let's discuss which factors impact the term of mortgage amortization and the total amount paid in interest.
How to pay off your mortgage faster?
First, you have to understand that there is no way to reduce your total payments below the initial amount of your mortgage. Some posts on the Internet and YouTube videos state some people were able to pay off their mortgages in just a few years. Indeed, this is possible, but you need to know that if you borrowed $300,000 from a bank, you will have to give it back no matter what.
However, you can reduce the mortgage amount by either buying smaller or providing a bigger downpayment.
Let's take 2 examples. In both cases, the maximum monthly payment you can afford is $1264. However, in the second case, you manage to get away with a lower mortgage (either through buying smaller or through a higher downpayment). This reduces the time to pay off your mortgage by 7.25 years and the amount you pay in interest by $60,110.
| $300,000 mortgage | $250,000 mortgage |
Monthly Payment | $1264 | $1264 |
Time to pay off the mortgage | 30 years | 22.75 years |
Total amount paid in interest | $155,330 | $95,220 |
OK, this works if you are still in the process of buying a home. But you already got one. How do you reduce your mortgage term and interest?
There are only 2 levers at your disposal to pay off the mortgage earlier: interest rate and amount of monthly payment.
A reduction in interest rate has a great impact on your payment. For example, assuming the same monthly payment, if a reduction of interest from 3% to 2.6% will save you $33,730 in interest and 2.2 years.
| 3% interest rate | 2.6% interest rate |
Monthly Payment | $1264 | $1264 |
Time to pay off the mortgage | 30 years | 27.8 years |
Total amount paid in interest | $155,330 | $121,600 |
During the course of your mortgage, you will be forced to refinance a few times. E.g. if your amortization period is 30 years and you picked 5-year fixed-rate plan every time you refinance, you will have to refinance 6 times. You should expect, that during these 30 years, the economy will change course a couple of times and the interest you pay will fluctuate. However, it makes sense to fight for lower rates each time. Making efforts to find better rates will pay off greatly down the road. To lower your rates you could do the following:
Don't just go to your preferred bank you have a checking account with. Reach out to a few financial institutions. When talking to banks representatives, mention the lowest rate you were able to find and see if they want to counteroffer.
Consider using the services of a mortgage broker. I wrote a post about mortgage brokers here: Mortgage Brokers and Agents: What do they do and how can they help you with your mortgage?
In times of a bad economy, when the government drops the rates for the banks to survive, mortgage rates also go down. While you are still locked in a mortgage term (usually 3 to 5 years) with your current bank it may benefit to break out from the current contract to lock a better rate. Good rates may not last long and by the time your current term is done, rates may go up. In most cases, you will have to pay a penalty for breaking the current mortgage contract early. However, when rates are low, in many cases the benefit of switching to a lower rate outweighs the penalty.
Increasing monthly payments is the second way to reduce your amortization period and the amount of interest. Let's look at 3 examples below. In the first, we keep the payment as is to pay the mortgage exactly in 30 years. For the second, we increase the monthly payment by 10%, in the third - by 20%.
| Normal payment | Increasing monthly payment by 10% | Increasing monthly payment by 20% |
Monthly Payment | $1264 | $1328 | $1518 |
Time to pay off the mortgage | 30 years | 26 years | 22.75 years |
Total amount paid in interest | $155,330 | $131,560 | $114,265 |
As you can see, increasing monthly payment has a great impact on the overall interest you pay and the mortgage amortization period.
You should note that the impact of increasing monthly payments reduces with the time you did it. E.g. increasing the monthly payment 10 years into the mortgage will have less impact than increasing it from day 1. Try to start extra payments as soon as possible.
Another trick that some people neglect is using times when the economy is bad and interest rates are low. When people refinance and get a lower rate, the bank representative automatically recalculates your monthly payment to stretch your contract to the original amortization period of your mortgage. Now, most people just go for the new payment. They think it is a bit less money to pay every month, they can save more. They also tell themselves that if they have a sizeable amount saved after a year, they will make a lump-sum payment. Guess what, this rarely happens. Instead of accepting the new, lower payment amount consider keeping the amount as it was. This will mean no change for your budget but will help pay the mortgage off earlier.
Do more frequent payments reduce mortgage terms and interest payments?
There is a common misconception that changing from a monthly to a bi-weekly or even weekly payment impacts your mortgage amortization term and the amount of interest you end up paying. This misconception likely comes from a vague knowledge that banks compound interest, so if you pay faster you don't let the interest compound as quickly.
The fact is, interest compounding is not done frequently enough for this to happen. Also, you pay off any interest that accumulates every month anyway. So, it cannot compound. See below for a comparison
| Paying Monthly | Paying Bi-weekly |
Number of payments | 360 | 780 |
Payment amount each period | $1264 | $583.38 |
Time to pay off the mortgage | 30 years | 30 years |
Total amount paid in interest | $155,330 | $155,027 |
The confusion stems from bank representatives sometimes using the term "bi-weekly payment" for what they mean "accelerated bi-weekly" payment. What this actually means is that they offer you to add an extra pay period for the year. This works like this: Let's say you were paying $1264 every month, which amounts to $15,168 per year. If you use an accelerated bi-weekly payment plan, you would be paying $1264 every 4 weeks (or $632 every 2 weeks). Thus, you would pay $15,168 in just 46 weeks of the year, and then an additional $1264 for the final 4 weeks of the year. This means you are technically paying more per year and repay your mortgage faster, ultimately reducing the amortization period and interest.
| Paying Monthly | Accelerated bi-weekly |
Number of payments | 360 | 780 |
Payment amount each period | $1264 | $632 |
Payment per year | $15,168 | $16,432 |
Time to pay off the mortgage | 30 years | 26.5 years |
Total amount paid in interest | $155,330 | $134,694 |
In summary:
More frequent payments have no impact on your amortization period and interest paid.
Better rates and increased monthly payments are the 2 factors with the most impact on the amortization period and interest.
Reducing the amount of mortgage upfront is a great way to reduce interest. Try to buy a property at a price that will allow you to pay the mortgage faster (in 10-15 years).