Removing the Mystery from …. Prepaying Principal
What does it mean to prepay principal?
Prepaying Principal on your loan refers to the act of paying extra principal beyond that which is required by your regular payment. Prepaying just a small amount of principal each month can have a dramatic effect on reducing interest payments long term and knocking many years off of the life of your loan. But does it always make sense to prepay principal? Are there two sides to the story? There are many factors that come into play and you need to understand exactly how this strategy operates in order to make an informed decision on whether or not to prepay and how much. Make sure you don’t have a prepayment penalty on your loan before you even consider prepaying however.
How does my loan get paid off?
First, contrary to what many sources would have you believe, there is no particular magic in prepayment. At any given point in time, the principal you owe is accruing interest at some rate. For example, let’s assume that your starting principal amount is 100,000 and your interest rate is fixed for 30 years at 10%. Your regular monthly payment would be 877.57/month for 30 years. While this amount remains the same for the life of the loan, the amounts that go towards principal and interest vary. In month one, 44.24 goes towards principal, and 833.33 goes towards interest. Each subsequent month, more goes towards principal and less to interest, until month 278 (23 yrs 2 mos) when principal has basically “caught up” with interest and, from there on out, principal continues to increase until your final payment, when 870.28 is principal and only 7.29 of your payment is interest. At this point, we say that your loan has been fully amortized or “killed off”, meaning that your loan is fully paid.
What many people fail to realize however is that, no matter what month you are in, interest always accumulates at that same 10% interest rate on the amount owed for principal. If you think about it, this kind of makes sense! While calculating an amortization schedule is complicated (let a mortgage calculator do it for you) the amount that you pay each month for interest is not. For example, with the terms described above, in month one, you owe 100,000 in principal. 10% of 100,000 is 10,000/yr which (dividing by twelve) is 833.33/month. Precisely the number shown above! At the “catch up” point in month 278 above, total principal owed is 52,426.82. Calculating interest for this month is again straightforward: 10% of 52,426.82 is 5,242.68/yr which is 436.89 for that month, leaving 877.57-436.89=440.68 going towards principal. Sure enough, we’ve reached the “catch up” point. And in month 360 (your last payment), the principal remaining on your loan is 874.25. 10% is 87.43/yr which is 7.29 in interest for your final month. Over the life of the loan, you’ve paid 216,000 for the privilege of borrowing 100,000 for your house. But the point is, just because your principal amount has been reduced by almost 50,000 or 99,900 doesn’t mean that the interest is calculated any differently!
What happens if I prepay principal?
So now we can look at the effects of prepaying principal. By prepaying an extra $100/month, this loan would be paid off in 19 years and 3 months! This is because the principal amount that you owe on the loan is reduced by an extra 100 each month, meaning that the interest that accrues each month is much smaller, and since the amount of your next monthly payment includes a smaller amount for interest, the portion of your payment that goes towards principal is now greater! This has a steamroll effect, resulting in a loan that is fully amortized in 19 years 3 months. The total amount of interest that you pay over the 19+ years is about 125,000. This is much smaller than the approximately 216,000 that you pay if you do not prepay principal.
Again, no magic here, just a smaller amount of principal on which interest can take it’s toll.
Should I prepay principal?
The arguments for both sides of the "prepay or not to prepay" are good ones. But any argument that takes just one side of the issue is shortsighted. Some say, "do not prepay" as you might prefer to have your money working for you, perhaps in the stock market, in your business, in a rental property or (perhaps the best reason) paying off consumer debt that carries a much higher interest rate. This case is especially strong when your rate is low. Remember, once you prepay, you may not ever get that money back at the same low rate. In some cases, especially if your interest rate is relatively low, you may not ever want to pay off your loan, and many people intentionally do not!
The other camp, which tends to be heard from more often, says that you should prepay as much as possible to save literally thousands in interest (91,000 in the case shown above) but, perhaps more importantly, it pays down your loan amount, enforces discipline in your savings as you build equity faster, and helps you sleep at night. But leaving credit card debt unpaid at 20% interest can cost you much, much more than not prepaying on your mortgage over 20 or 30 years.
It really becomes a personal decision based on your financial situation, your discipline, and your comfort level.
How do I prepay principal?
You can amortize your loan more quickly and hence decrease the amount of interest you pay over the life of the loan by either paying more or paying sooner (where sooner actually is the same as more). There is no fundamental mathematical difference in the methodology that you use to accomplish this. However, perhaps the best way is to do it within the framework of your current repayment method, i.e. prepay monthly because it is simple and, best of all, it is usually free!
What about those biweekly payment plans?
Biweekly payment plans advertise that you can save thousands of dollars in interest by paying every two weeks instead of monthly. But the concept here is really no different than we’ve just discussed.
For example, let’s assume that your monthly payment is $1000. If you pay biweekly, you make 26 payments of $500 (=13,000 annually) instead of twelve monthly payments of 1000 (=12,000 annually). You’ve prepaid an extra one month or $1000 annually. But you can accomplish essentially the same thing by prepaying the extra $1000 on a monthly basis. In other words, you can pay an extra $1000/12 = $83.33/month as part of your monthly payment at no extra cost. Many times, the biweekly plans have an initial charge and then a recurring monthly charge. Why would you want to pay for that? Wouldn’t you prefer to put those fees towards your principal? Some folks like the biweekly plan because it aligns better with their paycheck frequency, which is fine, but understand that you may be paying extra for this convenience.
The bottom line is that your interest rate and the amount of principal you owe at any point in time determine how much you will pay in interest. It doesn’t matter whether you owe $500,000 or $50, the cost of borrowing money is still based on the same interest rate. The question you need to answer is, “Am I better off paying down my principal at x%, or is that money better used elsewhere?”
The numbers can get messy and you may not have the time to unravel all the variables, but you don’t have to. Call us and we’ll do it for you. At Apple Street Mortgage, we work through these numbers all the time and we’ll ask the right questions to help you understand your options and make an informed decision for your specific circumstances.