In these tricky economic times, if your stockbroker told you he had an investment that was guaranteed to get you a 5 to 10 percent return, you would call him a crook. After all, we’ve been taught that no investment is a sure thing — especially now. But that’s exactly what prepaying your mortgage is: an investment that’s guaranteed to get you a return equal to the amount of your interest rate.
Let me illustrate this with an example. Let’s say you have a $200,000 mortgage. It’s a 30-year fixed at 7 percent. Your monthly payment is $1,331. By sending in just $50 extra per month over the course of your 30-year mortgage you will save $36, 427. Most people, if they put their minds to it, can squeeze out an extra $50, even these days.
How does so little achieve so much? Here’s how you do it. When you pay your monthly mortgage, send in extra money and specify that it is to go toward reducing your loan amount — the principal. The bank bases its interest charges on that principal, so by reducing the amount of principal, there is less for it to charge you interest on. Another way of putting it: The extra $50 you sent in is $50 the bank will never get to charge you interest on. Not now. Not over the 30 years of your loan. Never.
When you send in extra money to pay down your principal, it doesn’t change your monthly payment (except with special mortgages). Rather, the extra money comes off the backend of your loan. The bank doesn’t get to charge you interest for as long, because once the principal is paid off, there’s nothing left to charge interest on. So, that extra $50 a month you pay will save you time in addition to money, as your mortgage will be paid off at least three years early.
But you don’t have to wait 27 years to experience the benefit of mortgage prepayment. Every time you send in extra money for your mortgage, you will save, even if you don’t keep the loan for long. That’s because each extra payment causes less money to go toward interest and more to go toward principal.
Let’s say you sell after 10 years. Prepayment would still benefit you. If you send in $50 extra per month for just a decade, you’ll still save $8,654. That’s all additional equity you can put toward your next home. There are people who are critical of mortgage prepayment as an “investment” strategy and in next week’s column I’ll take them on.