On any loan, your monthly payment is divided between two purposes. First, part of the payment is used to cover the interest that has accrued on your balance since you made your last payment. Second, any remaining portion of your payment goes toward reducing your loan balance. Because of this, once you have paid the interest for a month, any extra money you add to your monthly payment will go directly toward reducing your loan balance. This can save you a lot of money in the long run.
Most of your savings comes from the fact your interest payment for every future month on your payment plan will be less than it would have been if you hadn't made the extra payment. The less interest you pay, the more of your regular monthly payment will go toward paying down principal. The effects really do snowball, often to significant end results.
Example of Saving Money by Adding to Monthly Payments
A concrete example can help illustrate how the savings adds up. Let's say you just took out a mortgage for $240,000 at 4% annual interest, with a repayment term of 30 years (or 360 monthly payments). Based on these numbers, your lender would calculate a monthly principal and interest payment of $1,145.80.
When you send your first payment of $1,145.80, your lender first covers the accrued interest. An annual interest rate of 4% is a monthly interest rate of 0.33%. Your loan balance is $240,000, so you would owe $240,000 x .00333333, or $800, in interest. Once that has been paid, the remaining $345.80 reduces your loan balance, so you now only owe the bank $239,654.20. The next month, you will only owe $798.85 in interest because your balance is lower, so you pay $346.95 toward principal and have a new loan balance of $239,307.25. After 360 payments, you will have paid a total of $172,486.82 in interest.
Now, say that you decide to make an extra mortgage payment of $200 every month. Your first month, you will pay the $800 in interest but pay off $545.80 of your loan balance, leaving you owing $239,454.20. The following month, your interest payment will be down to $798.18 (67 cents less than if you hadn't made the extra payment), and you will pay $547.62 of your loan balance, reducing it to $238,906.59. If you continue this, you will pay off the mortgage 88 months early. The best part is you will have only paid $124,979.70 in interest, for savings of $47,507.12. That's a big result from a relatively small monthly difference.