I know that these are a thing and that early payments will have a larger dollar amount dedicated to finance fees and less to the principal amount and that later it shifts towards the principal, but why? How does it benefit the bank to do it this way? What are the effects of paying off the loan early? Is there anything else the typical consumer should know?

In: Other

Since the amount of interest in a standard mortgage is a fixed %-based on the amount of principal you owe, the smaller the amount of money owed in total, the lower total interest is owed on that remaining money. (those where the interest rate changes, ARM loans, are a whole ‘nother can of worms)

There’s three key things here

1. **As you pay off your loan, your principal balance lowers, so your %-based interest owed also goes down**

2. The longer you take to pay off a loan, the more you’ve paid in interest

3. We’ve settled on loan repayment that has the same monthly cost every month until you’re done and a fixed length (15 or 30 years).

1. Some reading on the history of this: [https://www.marketplace.org/2018/10/31/why-do-we-have-30-year-mortgage-anyway/](https://www.marketplace.org/2018/10/31/why-do-we-have-30-year-mortgage-anyway/)

When you first have a loan, you own *much* more interest than towards the end of your loan.

$500,000 house with 2% interest rate = owe $10,000 in interest

$5,000 left on that *same loan* = owe $10 in interest

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Taking an example with nice round numbers:

If I charge you 1% interest/month on $100,000 dollars, the first month’s interest is $1000. If you pay me $2000, I take $1000 for interest, and $1000 for principal, meaning you now owe me $99,000.

The next month, your interest is lower because your principal is lower. Specifically, your interest owed is now $990. if you pay me $2000 again, then your interest payment was $990 (less than before) and your principal payment was $1100, so your loan goes down to $97,900: a bigger decrease for the same total payment.

Paying off a loan early, **unless you have a prepayment penalty**, means you pay less money overall. Similarly, if you make extra payments **and specify that the extra are towards the principal,** you’ll pay less money overall. Most banks will *not* put it all towards the principal unless you tell them to.

If you don’t changing the rate, and you don’t increase the amount of principal paid, you would have shrinking loan payments each month.

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Back to my simplified example:

Instead of paying $2000 again for the loan the second month, you pay me $1990: $1k towards principal, $990 towards interest. This means your principal reduces by less, and simultaneously the bank gets less money from you each month. Furthermore, since the principal is reduced by less each month, the loan takes longer to pay off.

Since we’ve mostly stuck with the 15 or 30 year loans, to do decreasing monthly payment model over the same time period, borrowers would have much higher initial monthly payments than with the current system, and people typically don’t want that.

> How does it benefit the bank to do it this way?

Can I borrow a dollar from you today?

OK now can I borrow a dollar from you in 1991?

Since it’s not the same dollar due to inflation, that 1991 dollar is now $1.96. So since you’re paying the same $1 in 2021, the bank is losing money due to inflation. That’s why most of the interest – i.e. its profit – is front loaded so the bank gets the profit in today’s money as opposed to how much less the money will be worth in 30 years.

> What are the effects of paying off the loan early?

I mean you can save a ton of money in interest but you can go overboard and actually pay more. You need to do the math there as far as bang for the buck. For instance, say your mortgage is $100k @ 3.5% 30-year fixed.

* your payment is $449.04/mo

* total interest paid over 30 years is $61,656.09 or about 61.66% over the life of the loan

If you pay an extra $300/mo, you will pay $26,868.94 in interest, a savings of $34,787.15… but you paid an extra $51,000 to get there so you’re effectively losing an extra $16,212.85 by paying it off early.

If you pay an extra $100/mo then you pay an extra $17,100 and pay $36,928.15 total interest which gives you $7,627.94 in overall reduced total payment. You can play with the numbers to see how much you can save vs. total paid.

> Is there anything else the typical consumer should know?

Lots of things:

* mortgage rates are low right now, which means housing prices are high. This isn’t sustainable but we should see low rates for the next few years at the most so plan accordingly but don’t overbuy the house because house values should have a correction soon enough and you don’t want to be stuck with a house that you overpaid for.

* some lenders give you a break on the rates if you get an escrow from them, i.e. you pay taxes and insurance on top of the mortgage payment to them. Do that and lock in the rate. Then, ask to dump escrow afterwards by paying a one-time fee of 1/8 of a point, i.e. $125 for every $100,000 you borrowed. This removes the escrow where you pay your own bills but your rate stays the same.

* if you cannot put down 20%, don’t get a mortgage where you have to pay for PMI. Instead you can get a second mortgage where both mortgages add up to 20%. You pay interest on both and – unlike PMI – can deduct interest on both from your taxes (you cannot deduct PMI). In addition, the second mortgage is going to be a much lower amount so once you pay that off, you’re home free with a 20% equity and no wasted money.

* don’t kill yourself paying a mortgage off early. See if you can put that money to better use like paying down other debt or investments. The returns on the stock market could be greater than interest saved on your mortgage.

* house values generally go up but they have a few bad years of corrections where you can get stuck. Don’t buy into risky markets and do NOT overextend. I.e. if you’re looking for a house for $250k, tell your broker you’re looking for $200k. That way when they show you a house for $225k, you’ll be fine.

* location, location, location. Good transportation, good schools, good neighborhood, all will increase house prices over time.

* avoid Home Owners Associations like the fascists they are. /r/FuckHOA for horror stories.

* plan to pay about a third of your monthly mortgage amount in taxes and insurance as far as figuring total budget

* don’t forget repairs and this is where you can do the math:

* buy a brand new house where no repairs are needed… but it’s more expensive, or

* buy an older house where repairs are likely needed… but it’s much cheaper

* that said, get a really good inspector. Their report – which should be at least a few pages long – will save you thousands if not tens of dollars

* never buy a property without a full inspection. Horror story: I know someone who bought a house and had to buy it fast so they didn’t get it inspected. Newer home and it looked good so no problem right? Wrong. Termites with a sagging foundation and the house had to be demolished within a year.

More of your payment goes towards interest in the beginning because the interest amount is based on the outstanding principal balance each month. For example, if you take out a mortgage for $150,000 with an interest rate of 3%, the interest on your first payment would be calculated as:

$150,000 (your outstanding principal balance) * .25% (your annual interest rate of 3% divided by 12 to get your monthly rate) = $375.00

So $375.00 of your first payment will go towards interest and the rest will go towards the principal.

Now let’s say that you’ve been paying on this for 5 years and your outstanding principal balance is now down to $135,000. For your next payment, the interest would be:

$135,000 * .25% = $337.50

As the principal balance goes down, so does the amount of your payment that goes toward interest, which means that more of your payment goes towards the principal.

When you take out a loan, the basic value of the loan is the principal. The interest and fees get tacked onto that, and the interest is a function of the outstanding loan amount.

Based on this, you must, at the very least, pay the interest and fees every month, or your loan will get larger. At the end of the loan, you’ll need to pay the entire principal back, as per the terms of the loan.

However, if you pay a bit more than interest and fees every month, then the principal of the loan decreases, which means the outstanding loan amount decreases. Since the interest is a function of the outstanding loan, next month’s interest will be slightly less. This means more of your payment (assuming you make the same payments every month) goes towards reducing the principal. This decreases the outstanding loan, which makes next month’s interest cheaper, and so on.

The bank wants this because they prefer money in hand over money that’s promised but might not come (defaulting). This is also better for you, because you can budget an entire 10, 20, or 30-year mortgage from the very beginning. You won’t have any surprises (hopefully, assuming a fixed interest rate and well-explained fees), and you’ll be able to schedule and budget for regular payments that will eventually pay off your loan at the correct term.

Paying more early is better, because each month the loan is outstanding, there is interest charged. If you can pay it off a year early, that’s 12 interest/fee payments that you don’t need to make; it saves you money.