Saw this question over at the Money Stack exchange site: Bigger mortgage downpayment vs. paying extra on the first regular payment? It's a great question with a slightly non-intuitive answer.
A number of things determine how much interest is paid on a mortgage:
- What the mortgage rate is.Obviously the lower the average rate over the course of the loan, the better. If the mortgage is a variable-rate mortgage, then the rate is likely lower at the beginning, and higher at the end, with the average rate somewhere in between. If it's a fixed-rate mortgage, then the average rate is the rate, of course.
- The term of the mortgage. A shorter-term mortgage like a 15-year fixed-rate mortgage will accrue less interest than a longer-term mortgage like a 30-year fixed mortgage, because (1) the money is borrowed for a longer time and (2) the rate on the longer-term mortgages are usually higher than the shorter-term mortgages.
- The type of mortgage. It's harder to determine which type (adjustable rate or fixed rate) will be the better deal after all is said and done, especially because we live in uncertain times with historically low interest rates. But it's probably safe to say that mortgage rates can't get a great deal lower.
- The amount of additional principal payments made. More principal payments above and beyond the base payment means less interest paid out later. Exceeding the minimum payment will help you to reduce your debt, whether it's credit card debt, student loan debt, auto debt, or mortgage debt.
- The amount borrowed in the first place. This supersedes all of the other factors. All other things being equal, if you borrow less, you'll pay less in interest. Borrow nothing, and you pay no interest! It's as simple as that.
The question above focuses on the last two factors.
A brief story from my own refinance
What a difference just a couple of weeks can make. When we refinanced the mortgage on our previous house, I had wanted to throw some cash at the loan so that my payment would be less. As it turned out, the amount of the refinance went through before I paid down a big chunk. So, my monthly payment amount didn't change, but instead reflected the original principal balance. I knocked down the principal up front, but not before the loan closed (with the borrowed amount set in stone).
Now for the slightly-counterintuitive part. If I had been planning to make only the minimum payment, I probably was better off keeping the higher payment but paying down a big chunk after closing on the loan. In other words, it was good that it worked out like it did.
The paydown up front means savings at the end
The reason why keeping the higher monthly payment, but paying down a bunch up front, is better is the total number of payments. With my paydown, I shaved almost two years' worth of payments off the end! My 15-year loan effectively because a 13-year loan, just like that. It's a bit of a forced paydown plan, because my minimum payment is higher, but at least the decision has been made for me, in essence.
Given the option to borrow less and have a lower monthly payment or not, though, is a tradeoff between monthly “breathing room” in the family budget and potentially more interest being paid on the loan over its lifetime. For someone who's motivated to get rid of the debt as quickly as possible, borrowing less and paying more than the minimum each month isn't a problem, but for someone who doesn't quite have the fire under their butt, it could settle back to a more costly (in the long run) mortgage.
But, either way, any accelerated pay-down is a good pay-down. It's better than no pay-down!
