The big day is here. You are about to sign loan documents on your new home. You're sitting across from an escrow officer affixing your signature to what seems to be a mountain of paper. There is one form that catches your eye. It's the "THE TRUTH IN LENDING DISCLOSURE STATEMENT." This piece of paper you are now reviewing is a result of Federal Reserve Regulation Z. Reg. Z carries out the consumer credit protections that were part of the Truth in Lending Act passed in 1968. One function of this Regulation requires lenders to give borrowers written disclosures as to the cost of credit expressed as a finance charge and annual percentage rate (APR). It is the finance charge that I will address at this time.
You decided to buy your home based on certain criteria. You determined that you can afford, let's say, $1468.00 per month for principal and interest. Based upon that knowledge and a current interest rate of 8.0% your loan will be $200,000. You look at the form . . . your eyes move to the right . . . you clutch your chest thinking that you're having heart attack. Your new home with a loan of $200,000 for 30 years, which you feel you can comfortably afford, is going to cost you $528,480.00. Your first question is, "Is this correct?"
Unfortunately, it is correct. Your $200,000 loan is going to cost you $328,480 in interest over 30 years. This is probably the reason we have 30 and 40 year loans . . . the pain can be spread out over a longer period of time.
What alternatives do we have in this situation? I know it is difficult to follow a series of numbers, but let's try. We have heard the term "prepayment." Prepayment is simply paying off all or part of the principal balance of a loan prior to maturity. In our scenario, we are going to look at prepaying a $200,000 loan on a monthly basis. By applying a small amount of extra money to your monthly mortgage payment to reduce principal, you can substantially change your financial future.
We know that it will cost you $1468 each month to pay off this $200,000 in 30 years. Over 30 years the interest expense on this loan will be $328,480. Let's now add to your monthly payment of $1468 an extra $200.00. Your payment will now be $1668 per month. What will that additional $200 do for you over the life of your loan? First, it will cut your loan term from 30 years to 20 years and 2 months. The other benefit you will receive is a reduction of your interest charge from $328,480 to $203,656. That is a savings of over $124,800. If you can afford $400 extra per month you will cut your loan term down to 15 years, 8 months and save over $177,296 in interest.
The numbers I gave you are just examples of what can be done to reduce the interest you pay on any home loan. Any amount of money you add to prepay your principal, be it large or small, prepaid monthly or in periodic lump sums, will shorten the term of your loan and reduce the amount of interest you pay.
Let's say you use the $200 per month approach. You now have paid off your loan in 20 years and 2 months. Since you are conditioned to making monthly payments of $1668, now you can make those same payments to your savings plan. In an account that pays just 8% over 10 years (the same 10 years that you would have been paying for your 30-year loan) you will accumulate over $262,592. Now, in 30 years not only is your home mortgage paid off but you also have a substantial amount of cash that can work for you. All it takes is "just a little bit extra!" Copyright © 1999, jjrmf.com