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    Deal GURU
    Join Date
    Mar 2007

    Default How Mortgage Prepayments Work

    How Mortgage Prepayments Work
    The Dollar Stretcher
    by Gary Foreman

    I once heard a financial planner say you can reduce the numbers of years it
    takes to pay your house off. She said that if you make one extra house
    payment a year, you could reduce a 30-year mortgage to 22 years and a
    15-year mortgage to a 12 years. Can you please explain how this works?
    RM in FL

    What RM heard was generally correct. But lower interest rates have changed
    it a bit. Let's explore mortgage prepayments and how to make them work.

    First, recognize that there's a big advantage to getting your mortgage paid
    off. It frees up a sizeable amount each month that can be used for other

    Yes, it's a big long-term goal. But, unlike some other distant goals, you
    don't need to get to the finish line to benefit from your efforts. Even if
    you only prepay principal one time, it will make every regular payment
    after that more efficient.

    RM will want to get familiar with something called an 'amortization table'.
    It shows month-by-month how much of each payment goes to paying interest,
    how much to reducing principal and what the remaining balance of the
    mortgage is.

    The key factor in paying off any mortgage is how much of the monthly
    payment goes to reducing the principal amount owed. For instance, RM would
    be in the 18th year of the 6% 30-year mortgage before half of his payment
    went to principal repayment.

    A 30-year mortgage for $150,000 at 6% interest will earn the mortgage
    company $173,757 in interest. The monthly payment will be $899.33. But in
    the first month only $149.33 of principal will be repaid.

    What happens if RM does make an extra payment each year? Fortunately a
    mortgage calculator does the math for us. I'm partial to one at

    One extra payment per year would reduce the length of the loan to 24 years
    and 9 months. It also would reduce the amount of interest paid over the
    life of the loan to $138,295.

    Back to RM's question. Why doesn't the annual prepayment reduce the 30-year
    mortgage to 22 years? It's because of the low interest rates. If the rate
    were 9.2% then one extra payment a year would reduce the term to 22 years.

    Same deal for a 15-year mortgage. At a rate of 5.25%, the mortgage would
    require a monthly payment of $1,205.82. One extra payment per year would
    reduce the term to 13 years and 5 months.

    OK, so we agree that prepaying your mortgage is a good thing. But for most
    families making an extra mortgage payment doesn't seem like a reasonable
    goal. Yet, it isn't impossible. One way to be successful is to break it
    down into 12 monthly parts.

    By adding $74.95 ($899.33 divided by 12) to each monthly payment RM would
    be doing the same thing as making one extra payment per year. The length of
    the mortgage drops to 24 years and 7 months.

    A simple change in lunch or entertainment habits could provide that much
    saving. Just think of it as trying to avoid spending $2.50 per day. Or, if
    reducing spending isn't possible, perhaps RM could use his next salary
    increase for mortgage prepayment.

    Refinancing your current mortgage could also be a solution. Instead of
    using the extra money for other things, continue making the same monthly
    payment that you made before the refinancing.

    Suppose that RM had a $150,000 8% mortgage and refinanced to 6%. The
    difference in payments is $201.32. But if RM continued to pay the $1,100
    that they had been paying before the refinancing, he'd have the mortgage
    paid off in 19 years and two months.

    Before you make any prepayments you need to check your mortgage for two
    things. First, verify that prepayments are allowed. Second, make sure that
    any extra amounts that you send in are applied to reducing principal. In
    fact, you'll probably need to indicate on your check or the payment stub
    how much extra is meant for principal reduction.

    It's a good idea to make sure that the bank is applying any prepayments
    correctly. More than one person has had a prepayment applied as an 'early
    payment' for the next payment due. That will not do you any good.

    There are services that charge to check your balance. But it's really not
    that difficult if you have a copy of the amortization table. Based on the
    previous month's principal owed, the table will tell you how much of your
    regular payment would go to reducing the principal. With that and the
    amount of your prepayment, you'll be able to calculate the new balance.
    Just verify that amount with the mortgage company by phone or the web.

    Gary Foreman is a former financial planner who currently edits The Dollar
    Stretcher <> website
    All of my posts were transferred from
    the budget101 Discussion list

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