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Why do people pay an "extra" amount when paying back a loan?

They do it to reduce the loan's interest charges, and to pay off the debt earlier.

If I make extra payments, how much will I save?

When will the loan be paid off?

The answer to both questions depends on the current balance, the loan's interest rate, when you start making extra payments, and the additional payment amount.

In some cases, usually for longer-term loans such as mortgages, the savings in interest charges can be quite substantial. If the borrower starts making the extra payments early enough, and for an amount that's not exceptionally large, it is possible to save tens of thousands of dollars on a $200,000 mortgage (the average size new mortgage balance as of 2017, according to the Consumer Financial Protection Bureau was $260,386).

Specifically, with an average mortgage, by making $200 a month extra payments, the borrower will save over $50,000 assuming a 30-year loan and a 4.25% interest rate.

How is this possible? What sleight of hand is taking place?

There's no sleight of hand. The future savings are a mathematical certainty. It all has to do with the way loans, and mortgages work. The periodic interest amount is calculated using the loan's current balance and multiplying it by the periodic interest rate - the lower the balance, the lower the interest amount due.

Thus when you prepay principal (make extra payments), you are lowering the loan balance used for calculating the interest due.

As I said, this is a mathematical certainty, and this calculator will show you just how much interest you'll save on any loan, and when the loan will be paid off.

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Sounds pretty good, right?

Of course it does!

But, what if I told you, "How much will I save if I make extra principal payments?", isn't the question you should be asking?

"What If I Invested the Money Rather than Make Extra Payments?"

Ahh, that's the more important question!

Rather than reducing interest costs via prepaying principal, what if you saved and invested the money? Would you be further ahead?

That's that critical question to be asking.

If you have $200 and you use it to make a prepayment toward a loan, you can't also use the same $200 for investing. Economists say, not being able to invest is a foregone opportunity. The opportunity to do something else with that same $200 won't come back. The chance is gone.

How then do you know which is the better decision?

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Use this calculator!

The calculator uses "Your Investment Rate-of-Return," and calculates the future value of all the projected extra payments. It then calculates the investment gain and subtracts it from the "Total Interest Saved" to arrive at the net gain from the extra payments (the "Interest Saved Less Investment Gain" shown).

Let's look at an example.

When you come to this page, you'll find the calculator preloaded with a $260,386 loan/mortgage, and $200 a month is the default prepayment amount.

For the investment rate-of-return, the calculator uses as a default 7.2%, which is the approximate average rate-of-return for the S&P 500 according to this (somewhat dated) analysis. (Dated, yes. But considering what the stock market has done since this study, my 7% assumption for deciding whether or not to make extra payments on a loan is conservative.)

You, of course, are free to use whatever rate-of-return you like.

Using these defaults, here are the results:

Savings from making extra payments
Extra payment calculator results. In this case, investing is more advantageous.

$52,829 in interest savings and the mortgage that would have usually taken 360 payments to pay off, will be paid off after 276 payments.

But, here's the real story.

If the borrower takes the $200 a month and invests it, after the 276 months, their investment GAIN will be $81,238! (Total value of the investment account will be $55,000 in extra payments invested plus the $81,238 gain equals $136,238.)

Now it should be apparent that while a $52,000 savings is terrific, an $81,000 gain is better.

Just how much better?

$28,409 better, as the final result "Interest Saved less Investment Gain" ($52,929 - $81,239) shows you.

If, after plugging in your numbers, you get a negative result too, then YOU SHOULD CONSIDER NOT MAKING EXTRA PAYMENTS!. You'll, at least hypothetically make more money from your investments than you save in interest charges.

Want to confirm the results?

Then make sure you click on the "Supporting Schedules" button. There you'll find all the supporting number that went into the above analysis. There's a detail amortization schedule showing the periodic payment and interest charges as well as the extra payments coming off the principal balance.

After the loan payment schedule, you'll find a future value or investment schedule. This schedule documents the capital gain from the invested extra payments.

Amortization schedule with extra payments
The amortization schedule with extra payments followed by the investment schedule

When might you want to continue to make extra principal payments even when the calculator indicates investing might be the more prudent course to follow?

There are at least two reasons I can think of when you might not want to invest the prepayment funds.

I can express one reason with a single word - Risk!

Remember when I was discussing why making prepaid principal payments saves the borrower money, I used the phrase "mathematical certainty?" If the borrower makes the extra payments as anticipated, then the interest savings is a sure thing. The lender can only charge the periodic interest on the outstanding balance of the loan.

But, if you invest, and even if you invest per the anticipated schedule, for the full amount and on the scheduled day, the return on the investment is likely not to be guaranteed (though true, some investment instruments might offer a guaranteed profit). In that case, at the end of the term, when the loan would have been paid off, you might not have the capital gains that you had anticipated. Of course, you might also have a more significant gain than what you had anticipated.

That's the risk.

The second reason why you might not want to invest is that you want to live debt free. I understand how when someone takes out a 30-year mortgage, they might dream of living without any mortgage debt in say 20 years. I get that. The fact is, that's how I felt, and that's what I did - but I did it before I created this calculator!

For here's the thing. It is possible to be both free of debt early and to implement an investment strategy for your funds rather than a principal prepayment strategy. They are not mutually exclusive!

Let me walk you through this, step-by-step:

Debt free date with extra payments
Debt free date with extra payments.
Balance on debt free date
You'll have a $92,929 loan balance on the debt free date when no extra payments are made.
Investment account's value as of debt free date
But there's over $136,000 in the investment account as of debt free date. You can still pay off the loan!
  1. Look at our example again - the one the calculator preloads when you first come to this page (click on your browser's refresh button if you want it back). At the time of this writing, the analysis shows the final payment scheduled for March 1, 2042. Make a note - that's the debt-free date with extra payments.
  2. Now set the extra payments to 0 and look at the schedule. This is the schedule without any additional payments. Find the balance as of the debt-free date. Again, as of this writing (these illustrations are time sensitive), the balance will be $92,929.
  3. Now, one more time, reenter the extra $200 payment amount and recheck the investment schedule located after the loan schedule. (The calculator prepares an investment schedule only if you have entered an extra payment amount AND if the option "Include the Investment Schedule?:" is set to "Yes.")
    • As shown, when making prepaid principal payments, the loan is paid off in 276 payments - or 23 years.
    • On March 1, 2042, the balance in the investment account will be $136,238.
    • You can easily pay off the mortgage using the funds in the investment account, live debt free as of the date planned, and still have nearly $40,000 remaining!

Of course, there is a rub.

This analysis overlooks the impact of taxes. If you live in the US, all or part of the interest may be deductible from your income taxes (though after the 2017 tax law changes, this is not as much of a certainty as it had been in the past). One the investment side, income taxes will frequently have to be paid on any investment gain, thus reducing the illustrated gain.

But even taxes on the gain are not a foregone conclusion. If you were to invest in tax-free bonds, then there is no tax on the income (but the illustration probably won't be as favorable). Or if you invest and don't sell along the way, the gain will compound tax-free. You'll only pay income taxes on the gain when you sell. And generally, income taxes on long term capital gains are very favorable to investors.

No doubt these points about taxes are something you need to consider. If I were to program the various tax considerations as options for this calculator, I think it would leave users very frustrated - not to mention me!

The Calculator's Features

Of course, your situation is likely different than this hypothetical example. So you'll want to use this Extra Payment Calculator to see just what you can save and when your loans will be paid off.

Let me take a few moments to go over some the other features this calculator supports.

If you don't plan to make extra payments monthly, that's okay. The calculator will let you make additional payments using any one of 11 payment frequencies set independently from when the scheduled payments are due.

For example, do you get an annual bonus? Do you want to use that bonus to prepay principal? This calculator will still calculate your saving under such a scenario. You can easily set it to make one or two extra payments a year.

Or do you want to make a one-time extra payment? That's no problem either. The calculator supports making a single extra payment on any date during the term of the loan. Perhaps you've received a one-time inheritance, and you are considering using it to reduce your loan's principal balance. The Extra Payment Calculator will tell you the amount of interest you'll save and when the pay off will be.

Don't forget to check out the amortization schedule for all the details.

(Perhaps I should also point out that the loan itself does not need to follow a monthly payment schedule. The last option on the Extra Payment tab allows the user to select any payment frequency.)

This Calculator is Not Just for New Loans.

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Up until now, I've been implying that the calculator is only for analyzing new loans. That's not the case. Perhaps you've been making loan payments for a few years, and you've recently received a raise. If you want to see the impact of making extra payments on an existing loan then there are no unknowns for the calculator to calculate (other than the effect of making the prepaid principal payments of course), so enter the following for the first four inputs:

  • The loan's balance as of the last payment due date.
  • The number of payments remaining.
  • The loan's interest rate.
  • The regular payment amount.

The calculator will use the terms of your loan for the analysis.

There is also one other setting to be aware of. On the "Extra Payments/Investment Rate" tab, please see "Is a Regular Payment Due Today?:" This setting impacts the analysis. It is set to "No" by default. However, if for the loan balance, you enter the balance as of the date a payment is due, then you should set this to "Yes." This prevents the calculator from adding the accrued interest since the last payment due date.

If you don't follow the above, please don't stress out. It won't make that big of a difference!

Don't Forget the Charts

No doubt if you spend time going over the schedules, you may find your eyes glazing over. (For sure, there are a lot of numbers!) If you find that happening to you, or if you aren't a detailed "numbers person," make sure you check out the nine charts that the calculator automatically creates.

Chart showing extra principal payments
Top chart showing extra principal payments. Bottom chart showing investment gain.
  • Annual Totals without Extra Payments
  • Annual Totals with Extra Payments
  • Annual Investment Plus the Annual Gain
  • Accumulated Totals without Extra Payments - running totals since the loan's origination
  • Accumulated Totals with Extra Payments
  • Accumulated Investments Plus the Total Gain - show year-over-year growth and final value
  • Pie Chart Loan Payment Total Allocated to Principal and Interest
  • Pie Chart Loan Payment Total Allocated to Principal and Interest with Extra Payments
  • Pie Chart Showing Breakout of Investments and the Gain on the Investments

Wrapping Up

When you were searching for an extra payment calculator, you probably just wanted to see how much interest you could save. You didn't expect there to be so many things to consider.

Don't feel as if you need to digest all of this in one sitting. Come back and try different scenarios. Make different assumptions.

But remember, the point is, no matter what decision you make, the calculator will help you to make an informed one.

You can let me know in the comments below.

Comments, suggestions & questions welcomed...

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