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When it comes to mortgage advice, some people recommend making an extra payment. The logic is :"These extra payments are automatically applied to your principal, not interest".

Why does it matter if the extra payment is applied to the principal and not interest?

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4 Answers

up vote 14 down vote accepted

Applying to principal now reduces the interest through the life of the mortgage. If you have principal of 100K and 10% APY, then by the end of the year (assuming no other payments are made) you'll owe 110K.

If you have a spare 1K and apply it to interest by the end of the year you'll owe 109K, but by the end of the next year you'll owe 119.9K.

If you apply it to principal, by the end of the year you'll owe 108.9K, and by the end of the next year you'll owe 119.79K.

Overall, just by applying to principal and not making any other payment, you saved 100 additional dollars in one year. Now, think of a 30-years fixed rate mortgage.

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Extra payments apply towards principal, and since interest is amortized and computed monthly.

The impact on your loan is pretty amazing. One extra payment per year will take about 8 years off of a 30 year fixed mortgage.

See a tool like http://www.mortgagecalculator.org for examples.

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I'm not sure where the "not interest" part of your quoted statement comes from; that's not the way this advice is normally given. Perhaps you worded the statement that way because you think there are only two possibilities: payments either are applied to the principal or to the interest? If so, there's a misunderstanding here.

Here are two other possibilities: (1) the mortgage holder puts the extra payments in escrow/holding, to be used in the future should you fail to make a payment; (2) the mortgage holder records the payment as being made in advance, without giving you any benefit (such as reduced interest). (Another way of thinking of this is that the mortgage holder moves up the due date, essentially giving you credit for having made the final payment. Unfortunately, this isn't just theoretical.)

In short, "applied to principal" is a shorthand way of saying that the mortgage holder treats the extra payment in a particular way (which benefits you the most), and not in a way (see (1) and (2), above) that benefits the mortgage holder the most.

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It's exactly the way I've always heard this advice given - because interest is amortized and calculated monthly, paying more now means you shorten the life of the loan. See @littleadv's answer –  warren Apr 25 '11 at 14:05
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This can be misleading.

Earlier payments are not automatically applied to principal in many jurisdictions. They are instead immediately applied to payments. In other words, over the life of a mortgage, many payments are scheduled, and they can even vary if the mortgage is not fixed-rate. If early payments are sent without specification in some jurisdictions, principal & interest may not even be prepaid instead payments will be accrued, so the principal is not reduced, thus interest is still being accrued off of the unreduced principal, and the investors or processor receives an interest-free short term loan in the form of a "payments accrued" account. This serves to raise the interest rate for the borrower and lower it for the lender or processor. As payments are due, and no new payments are made, the payments accrued account funds the payment due.

Early payments must be specified to "apply to principal". They could even be applied to interest, but this would be a waste since it effectively raises the interest rate.

Paying the principal instead of a full payment or even interest alone will reduce the amount owed, substituting cash for equity assuming the value of the home doesn't fall, while keeping the interest rate constant. Paying any payment or interest early only serves to increase the investor's interest rate since that money is received faster and can be reinvested elsewhere.

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Thanks. Can you elaborate:"They are instead immediately applied to payments." –  Victor123 Jan 30 at 14:40
    
@Kaushik Please note edit. –  quantycuenta Jan 30 at 15:34
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