If you pay extra toward the principle on your mortgage every month, eventually you'll pay it off earlier and you will pay less interest. At that point you should be able to figure out what your effective APR was, not what you were charged, but what you paid ....
Is there any way to work this out in advance that anybody knows of?! .... am I not even thinking straight?
For example -- say I got a 7% mortgage offer that was $1000 a month but I wanted to pay enough each month in addition to have the interest have say a 3% impact on the final bill - is is possible to work out?
If this is a fixed loan, your APR should stay the same, every month you are charged interest on your remaining principal, and the part of payment that exceeds interest applies to the principal.
If your loan was variable, you can find out the equivalent fixed APR at the end of the loan, if you know how much interest you paid over the lifetime of the loan.
You are mixing issues here. A 7% fixed mortgage is 7%. You can pay extra, but regardless, your interest rate is 7% on the remaining balance. In the last month of the mortgage, when you might owe only $100, it still accrues at 7%. Taking 7%, and multiplying by 30 to somehow claim 210%, or citing the total interest over 30 years and dividing by the original balance is all nonsense. There are many simple spreadsheets for amortization tables that will help you track your progress or calculate the payment required to cut the term to whatever you wish. In this economy, why are you even looking at a 7% mortgage, or is this completely hypothetical? Joe
Your APR doesn't change because you paid it down any faster.
Perhaps you mean something else entirely, but what you wrote above doesn't make any sense.
Just because you paid a loan off faster doesn't mean the interest rate changed.
Now, one thing that annoys me very much is the nonsense calculation that mortgage brokers are required to show you - the "total interest paid" over the life of the loan. It's nonsense because it ignores time value of money and the term of the loan.
If you pay your principal down faster than the original schedule, of course, over the life of the loan, you'll pay less total interest. Perhaps that's what you mean?
But that has nothing to do with your rate of interest, or the effective rate of return on money you use to prepay that mortgage as compared to using that extra money for something else. Again, the relevant factor is your (fixed) interest rate - and that is not affected by whether you prepay or not.
Another way to look at this is that interest is like paying rent on borrowed money. If you borrow for less time, you pay less total rent. But the rate of rent stays the same no matter how long you keep the borrowed money.
I hear you on that point, it's perfectly valid, but on the flip side I like it as an illustration of the cash outlay that you're committing to over the life of the mortgage. It should be a bit of a wake-up call for some people, that it's an enormous expense that is going to eat a certain portion of your future earnings - if you lose your job, you need the cash to pay that, TVM issues aside. I don't think it's particularly effective towards that goal, unfortunately, but at least the information is there for people who don't have or know how to use a financial calculator.
A related issue is the "tax benefit" associated with that mortgage interest. People think of that as reducing the mortgage cost, and for many it does. But the standard deduction in 2009, MFJ, is now up to $11,400, and that's only going up over time (while the mortgage interest component to a mortgage gradually declines as you pay down principal). This means that a lot of people aren't really going to get much of a mortgage-interest tax benefit - fewer and fewer as the years roll on - and so lifetime interest cost is more "real" (there's no offsetting tax benefit at a certain point, for many). If incomes rise, that certainly helps.
You have to remember that while the extra payments each month result in less total interest, suggesting a lower APR, it is also paid over a shorter time, suggesting a higher APR. It balances out, so like the others say, the APR will be the same.
AFAIC, what you want to aim for is giving as little money away to the banks as possible, in the form of interest and the all-too-common refinancing fees, and ensuring you and yours always have a roof you own over your head. Well, the roof and everything underneath it, that is.
You might like to become familiar with the many free online amortization calculators that include the option of an extra payment each month. E.g.
But it is a false reduction. Money has both a time value and an opportunity cost. By paying more now on your loan, you do reduce what you pay on the back end. But you also tie up more money now, which reduces your opportunity to do other things with the money, such as invest it. You may save money on your loan, but at the same time, you may have earned even more if you had invested that money that you used to prepay your loan.
I agree with the time value of money and the opportunity cost. I disagree with "But it is a false reduction". I t *could* be a false reduction if the money you invested elsewhere were to outperform your interest and principal payments. That hasn't been the easiest thing to do over recent years. "you *may* have earned even more" is a key phrase in your post.
I'll not speak for John, but I nodded when I read his post, agreeing. I read 'false' to mean that the number is simply not accurate. There is a risk free rate one knows at any time, right? It's low now, but was
4-5% not long ago. There's also inflation, which cannot be accurately predicted, but it's there. I respect Tad's view (regarding tax deduction), but it's specific to each person. I am so far beyond STD deduction, I am not worried about ever losing my mortgage deduction. Property tax and state tax fill the bucket well. So, a 5% mortgage can actually cost one as little as 3% or so after tax, and if one can get an after tax return near this (my state muni bonds are over 4%), then that 'savings' is nil. If you will assign risk to those munis, let's drop to 2%. Over the 30 year mortgage, there's quite a difference calculating the saved interest at 5%, vs the 'real' savings of 1% or so.
To simplify this - paying off the mortgage early is equal to investing in a treasury at the mortgage rate. So regardless, there can be reduction, but it's not the full interest saved.
Yes. you have to weigh the 100% certain gain when reducing the debt against the uncertain possibility of earning more by investing the money. A lot of people make it sound like the latter is easy. My guess is that, even in good times when the investment climate is favorable, it is not as easy to beat the interest rate on the debt as it is often made out to be.
=Maybe what you are trying to do is see how much you need to pay to pay it off if it was a 3% loan. You could use a program like TValue5 to calculate how long it would take to amortize it if it were 3% using $ 1000 payments. This would reduce the payout period considerable. You could then use the same payout period at 7% and calculate the required monthly payment to amortize it over that many years. For example: if it took 30 years at 7% & $ 1000 per month and only 15 years at 3%, then you need to calculate the monthly payment to amortize it at 7% over 15 years.
I have owned two homes. The first I bought with a mortgage. $27,000. I sold it in 1989 for $125,000 after about 14 years. The second home I paid cash for. I paid $238,000 for it and could sell it for almost $500,000 now, it peaked at about $560,000 but I don't have to tell you about the market. I didn't get a mortgage interest deduction but those deductions are expensive. What I got was a nice place to live, no mortgage payment to worry about, and a bird in the hand investment. My first house paid me back for everything I put into it. All taxes, mortgage payments, and upkeep didn't come anywhere near the $125,000 sale price minus the purchase price. Now, I'm in a very nice home in a desirable neighborhood and it cost me about $600/month for taxes and insurance. I couldn't live in a slum 2 bedroom apartment for twice that. I guess what I'm trying to say is that not all gains are financial, peace of mind is important as well, but in spite of the real estate market I'm reasonably satisfied with the price performance of the property even though I have no desire to sell it. There's more to this than dollar calculations and the outlook of the markets.
Perhaps, but the math shouldn't be ignored. It can be quantified, whereas 'peace of mind' is tough. Can we agree than when rates were 15% on fixed rate mortgages, it was a good idea to pay accelerated? (After the 30% credit card of course) And if you have a 4% fixed, but find that 5 year treasuries are now at
8%, that *not paying early* makes more sense?
If you believe that one having a $200K mortgage and $200K in cash equivalents is less happy than the guy that has the paid house, all else equal, then that's another story.
BTW, the OP asked about numbers and wasn't expressing the emotion either way.
Ok, it's tough, unless you have a $2,000/month mortgage and lose your job :-)
That was a relatively short period over the life of the mortgage. Since you brought it up, my lender actually offered to accept $17,000 to pay off my loan which had a much higher principle balance at the time. If I had the $17,000 I would have bought some of those treasuries that were paying double digit interest instead.
I do and yes it is.
Wonder what he'd do if he had the money to pay it off. Anyway, I've been in several of these discussions over the years. All of the calculations, the what ifs, the projections, etc. I'm really glad that I paid cash. Anyway, I'm not sure what the tax brackets are these days but if there was a 30% bracket, you have to spend $1,000 on interest to get $300 back. No thanks.
Inflation impacts both sides of the equation equally doesn't it. If you invest in treasuries/munis or you pay off your mortgage.
And of course there is risk in the munis. In the last year my muni funds are down across the board. The capital loss is higher than the interest rate. Personally I think we haven't seen the worst of the muni bond market yet. We have lots of defaults to come, with state and local finances being is a terrible mess. The picture is only now emerging about how bad that problem is going to be.
Finally, there is some subset of taxpayers for whom the effective after-tax rate is actually the nominal rate times (1 minus the combined federal + state marginal income tax rate). It is a rapidly shrinking subset, because as your income goes higher you get hit with AMT. As your income gets lower the deductions tend to get smaller, and more and more of it is just covering the STD deduction. After all, there is some correlation between income and (property tax + state income tax).
For example, both my parents and I consider ourselves to be middle class. Neither of us comes close to realizing the full benefit of the mortgage interest deduction. They paid off their mortgage when they realized that they were paying taxes on their investment yields, but more than half the mortgage deduction was going to just cover the STD deduction. We on the other hand are getting hammered by the AMT.
Actually out of the seven households in our family (parents and six kids with spouses) not a single one can take the full mortgage interest deduction.
It is a pet peeve of mine that everyone talks about the mortgage interest deduction as if it is a slam dunk. For the two classes of people for whom I have done volunteer tax prep, it seems to come them as a complete surprise that they are not getting the benefit they think they are. Especially young people who have bought their first house are usually amazed to find that their taxes don't go down much when they switch from renting to owning. Their parents tell them their taxes will go down, their realtor tells them the same thing, the mortgage broker chimes in, their friends who own houses do as well. Then they find out when filling out their tax return that in exhange for deducting 13000 in interest and taxes, they have to give up 10700 in the standard deduction. I don't think 90% of them even realize that this is a trade-off.
Unfortunately, two years later they are telling their friends how great it is to be able to deduct interest and property taxes on their tax form! They have basically forgotten all about the standard deduction.
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Please note that while this seems huge, it is only a 9.25% rate of return. And this happened during years when the money market was at 14% and it went through the two biggest boom periods in the stock market history. In addition, it required the biggest housing bubble in recorded history to get to these home values.
I realize all of that. I have been investing for 30 years or so in stocks and funds. Imagine though, if you paid cash for your home in 1989 as I did and instead of having a mortgage you invested $2,500 into the market each month. Then sold all of your equity holdings in 2000 and just started re-entering now. My point is that it's unpredictable. If you want to deal in just the numbers, consider this. I own my home and it costs me about $600/month in taxes and insurance. I'm 63. If I wanted to I could rent my house for about $2,800/month. My neighbor has been doing that for about 16 years, he gets $2,500/month but I have a much nicer/larger home. He didn't like the commute so he bought a condo closer to work and the lease on his house pays for all of it. I could do similar in Florida for winter and Canada in the summer and just rent out the house to pay for it. You can't do that with an index fund. I'm not in any way putting down equity investing, I've done quite well over the years. Everyone is different.
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