If you’re buying a home today, you’re faced with a ton of home mortgage options. And, each option is going to have a different effect on your finances. Some have short-term benefits that cost you more in the long run, while others carry significant long-term savings. Regardless of what kind of loan you choose, there’s one thing you can always influence—even if you’re already 5 years into a 30-year mortgage—to improve your financial position.
Time is always on your side
Most of us understand that a lower interest rate can save you thousands over time. One often-overlooked variable, though, is the length of time over which you spread the monthly payments—this is referred to as the amortization of the loan.
When taking out a loan, you usually have the option of choosing a 20-year or 30-year mortgage. Which one is the better option? At first, it might seem as though a 30-year mortgage would be the better deal, right? After all, spreading the payments out longer means the monthly payment is less. However, once you run the numbers, the amount of the monthly payment isn’t the only thing that matters.
Before we dig in, though, let’s first take a step back and look at one of the wonders of the ancient world—the Egyptian pyramids.
Building a pyramid
Witnessing the construction of the pyramids must have carried a similar feeling to driving through Central Texas on IH-35, “Are they ever going to get this thing finished?!”
With the pyramids, laying one of the massive stones couldn’t have seemed like much of an accomplishment, considering there was no real visual change and there were thousands more stones to place. After many years of laying stones, however, a giant pyramid was created that—still to this day—attracts thousands of travelers from all over the world.
How you manage your mortgage is (in some ways) like building a pyramid. Every extra payment you make is another stone added, pushing you closer and closer to the top of the pyramid. Making the extra payments may seem though, and it may seem like you’re not getting anywhere, but in the overall picture, you’re building up your personal wealth.
20-year vs. 30-year mortgage
Let’s say you have a $100,000 mortgage with an annual interest rate of 4 percent. If you choose a 20-year mortgage, you’ll be paying about $605 per month (excluding insurance and taxes). That same mortgage—spread out over 30 years—will run you $475 per month. The $475 payment certainly seems more appealing. But, is it really?
With the 30-year mortgage, the cumulative interest you’ll pay over the life of the loan is $71,870. How much interest would you pay with the 20-year mortgage? The answer: $45,430. The difference is astonishing! Think about what you can do with that extra $25,000. Is saving the $130/month difference worth the extra $25,000 you’d end up paying over the life of the loan? Is it worth making monthly payments for an extra 10 years?
The best of both worlds
Depending on your financial position when you first took out the loan, you may have only been able to afford the payment associated with the 30-year mortgage. But, just because you have a 30-year mortgage doesn’t mean you have to take all 30 years to pay it back. Most lenders allow the borrower to pay extra principal throughout the life of the loan.
One excellent way to cut down on the length of your loan is to simply round up your payment each month. For instance, if your monthly payment is $775, think of it as $800. An extra $25 each month on a $200,000, 30-year mortgage can save you twelve payments at the end of the loan. It’ll also save you about $4,000 in interest expense that you’ll forego by paying off your loan ahead of schedule.
Helpful Tip: A great way to see how much you can save by increasing your monthly payment is by playing with a mortgage calculator.
Applying an extra $25, $50, or $150 to your monthly payment won’t necessarily feel like much of an achievement, but it’s another stone successfully placed in the construction of your financial pyramid.
About the Author:
Travis Rollins is a credit analyst at Central National Bank. An Eagle Scout, Travis enjoys camping and being outdoors. He also enjoys traveling, relaxing in his hammock, and hanging out with friends and family.