How compound interest works for home mortgages
Compound interest works the other way, too. Though a savings account will increase the money you earn each month, many home mortgages use compound interest to determine what you’ll pay in interest each month.
For instance, if you’re buying a home, you may have a mortgage that compounds monthly. That means each month, the current outstanding interest will get added back to your principal. Other mortgages may compound weekly or daily.
Unless you can pay in full in cash when you buy your house, you’ll encounter interest over the course of your mortgage. A real estate professional can walk you through what your monthly payments will look like, but there are a couple of ways to reduce the amount of interest you have to pay on a home mortgage:
Pay more than your monthly payment each month
Any money that goes beyond your monthly payment will be applied exclusively to your principal. For example, if your monthly payment is typically $2,000 (including principal and interest), you could set your monthly payment to be $2,100, with the additional $100 going toward paying off your principal.
While this can be a good strategy, never spend outside of your means simply to pay a mortgage off more quickly.
Set up a biweekly payment plan
A biweekly payment plan is just what it sounds like: you’ll pay off your mortgage every two weeks. Using the example above, a $2,000 monthly payment would be broken down into $1,000 payments every two weeks.
A typical mortgage has 12 payments per year — one for each month. With a biweekly payment plan, you’re actually making 26 payments split up over the year. In other words, you’re getting an extra month knocked off your principal every year.
Biweekly payments can be a quicker way to pay off your mortgage. You’re contributing an extra monthly payment every year that goes toward your principal. And because you’re making more payments, you’re reducing the amount of interest you’ll pay over the course of the loan.
However, be careful when considering a switch to a biweekly payment. Make sure you can still afford a withdrawal twice a month (especially if you’re not paid on a regular schedule) and have a good sense of your finances before making the switch. Once you do, you can’t change back.