What's faster for mortgage payoff: $100/month extra or 1 payment/year extra?
Recently, a reader with a 15-year mortgage and an interest in accelerated mortgage payoff asked if it was better to pay $100 per month extra ($1,200 per year) or make an extra payment at the end of each year? The short answer: it depends on your loan balance and interest rate, though generally the higher extra payment is going to result in a faster payoff. There's more, but I'll go ahead and put my disclaimer here and say that I am responding to an inquiry not necessarily recommending that you pay extra on your mortgage. (See also: Top 10 Real Estate Write-Offs)
Here are the detailed calculations:
As with any financial calculation, you have to make assumptions so I've created these: $200,000 loan balance, 15-year fixed rate mortgage, and 5.93% interest rate (which was bankrate.com's average rate when I first starting researching this question on August 3, 2007). So, your monthly payment (principal and interest not including escrow amounts) is $1,680.16.
Add $100 to the monthly payment and you will pay off the loan in 165 months (13.75 years); or add an extra payment at the end of each year and you'll pay off the loan in 160 months (13.33 years). Just for fun, I did calculations on balances from $100,000 to $400,000 at the 5.93% rate and, if you make the one extra payment every year, you will always pay off the loan in 160 months. However, if the loan balance is $100,000 and you pay $100 extra each month, then you will pay off the loan in 152 months (12.67 years); if your loan balance is $400,000, the payoff is at 172 months (14.33 years).
Now you may be wondering if there is any advantage in making extra monthly payments throughout the year rather than waiting until the end of the year. There is a slight advantage. For example, if you took that extra payment amount ($1,680.16), divvied it into 12 equal payments ($140), and then paid $140 extra each month, then you would pay off the loan in 159 months (rather than 160 months if you paid the $1,680.16 at the end of the year, every year).
Also, why would you want a 15-year mortgage?
Generally, 15-year mortgages will offer a lower interest rate. So, over the life of the loan, you will pay substantially less interest as compared to a 30-year loan because 1) you are paying more principal earlier in the life of the loan, and 2) you have a lower interest rate.
Here are some differences between the 15-year and 30-year fixed rate mortgage, given a $200,000 balance and a 6.26% rate on the 30-year, fixed rate mortgage.
- Monthly payment: $1,680.16
- Total Payment: $302,428.68
- Monthly payment: $1,232.74
- Total Payment: $443,784.77
Differences between 15-year and 30-year fixed rate mortgage
- Monthly payment: $447.42 more for the 15-year mortgage
- Total Payment: $141,356.08 more for the 30-year mortgage
You could take that extra $447.42 and invest it rather than put it toward your mortgage; if you earned more than 6.26%, you'd come out ahead (not considering tax implications).
Still, there is something attractive about paying off a mortgage in 15 years. Here are some scenarios where the shorter, lower rate mortgage makes sense:
- You want to save as much in interest as possible and you want to be debt-free as quickly as possible.
- You are fully investing in your 401(k) and any other nontaxable accounts for which you are eligible.
- You are saving and investing regularly.
- You don't want to think about accelerating your mortgage payoff anymore. (To me, the 15-year mortgage offers a built-in acceleration.)
- You and/or family members like the way that the shorter-term mortgage helps you stick to a budget. (That is, you may be likely to spend the extra $400+ per month rather than invest it if you don't opt for the longer-term loan.)
If anyone is clamoring for a spreadsheet to do your own calculations on a 15-year fixed rate mortgage, let me know and I'll upload one. Or check out my 30-year mortgage schedules at DIY Mortgage Acceleration.