For many, homeownership represents the ultimate American Dream. And for most of these people, the way to achieve that dream is to take out a mortgage in order to finance that home.
Here's the problem: When you take out a 30-year mortgage, which many of us do, you wind up paying more interest than you may have realized. Let's say you've got a 30-year, $200,000 fixed mortgage at 5% interest. If you make your monthly payment as required, then you'll wind up paying a total of $186,512 in interest over time, which is almost as much as the principal.
See, when you make a mortgage payment, a portion of that money goes toward the principal amount of your loan, and the other part goes toward interest. During the early years of your mortgage, your payments will primarily go toward interest, but over time, your principal payments will increase, and your interest payments will decrease. That's because you're charged interest based on your outstanding principal.
So how do you save money on those interest charges? It's simple: Pay down that principal sooner. That sounds painfully obvious, but you may not realize there's a relatively painless way to do it.
Of course, if you had a large chunk of cash available, you probably would've taken out a smaller mortgage in the first place. But here's an easy way to chip away at that principal more quickly. Instead of making your regular monthly payment, take that amount, divide it in two, and pay it every two weeks.
Using our example, your $200,000 mortgage at 5% would translate into a monthly payment of $1,073.64. If you take that figure and divide it by two, you're looking at a payment of $536.82 every two weeks. What'll happen over the course of a year is that you'll end up making the equivalent of one extra monthly payment, except you won't miss that money nearly as much as you would if you forked over a lump sum of cash to pay down your mortgage.
Now watch what happens next: Instead of paying $186,511 in interest over the course of your loan, you'll wind up paying just $151,787 by making biweekly payments. That's almost $35,000 in savings right there. Not only that, but you'll also shave close to five years off the life of your loan.
Entering retirement debt-free
Aside from saving yourself loads of money in interest charges, paying off your mortgage early could also spell the difference between carrying that debt into retirement and leaving the workforce debt-free. In 2011, an estimated 6.1 million homeowners aged 65 and older were still making monthly mortgage payments, whereas a decade prior, only about half as many people in that same age group still carried mortgage debt. Many people who plan for retirement do so with the assumption that their monthly expenses will go down once they've left the workforce, but if you're still liable for a mortgage payment, then you could find yourself financially squeezed.
Of course, if you find you're able to apply a lump-sum payment toward your mortgage, then you can achieve the same goal of paying off your loan more quickly and saving yourself thousands of dollars in interest payments.
Say you receive a $20,000 bonus or inheritance and you apply it to your mortgage during the first year of your loan. Rather than pay $186,511 in interest, you'll knock your lifetime interest payments down to $131,551. In other words, putting in $20,000 will actually save you close to $55,000 over time, not to mention that you'll be able to shorten your loan by about six years.
And it doesn't have to be a monumental amount to make a difference. Even a small extra payment here and there can really add up. Say you manage to put only $2,000 extra toward your mortgage that first year. You'll still knock your total interest payment down to $179,954 and save a total of $6,557. Plus, you'll shave seven months off the life of your loan.
Remember: When a bank lends you money to buy a home, it does so to profit. The sooner you pay down your principal, the less money you'll lose to interest, which means you'll have more cash available to invest for retirement, college, or whatever other life goal you see fit.
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