Partial mortgage prepayment? What's that?When you pay a mortgage earlier than expected, that's prepayment. Mortgages can be prepaid "fully" or "partially." When a homeowner refinances, a new mortgage "fully" pays off the old mortgage and starts a new series of payments. Partial prepayment is the addition of extra payments to mortgage principal. Let's level set on the three fundamentals of partial prepayment. |
1. Mortgage balance decrease = equity increaseHome equity is the difference between the home price and the mortgage balance. Adding an extra payment decreases the mortgage balance and simultaneously increases equity. For example, a $25,000 prepayment to principal (green) in month 50 decreases the loan balance (purple) by $25,000 immediately. |
2. A cascade of interest savingsPrepayment starts a cascade of savings because mortgages accrue simple interest every month. The simple interest formula is "principal x rate x time." For a $500k loan, the first interest payment is $2,500 ($500k x 6% x 1/12). Interest gradually decreases over time. If the loan balance is lowered by $25k in month 50, the simple interest due for month 51 is $125 lower ($25k x 6% x 1/12). Since the minimum monthly payment is fixed, $125 does not materialize as cash savings and is applied to principal in the following month. Interest savings in month 52 are $125.625 ($25,125 x 6% x 1/12). This cascading effect continues for a total savings of ~$82,000! |
3. A shorter loan in the endPrepayments reduce the principal balance and "kill" the loan faster than 30yrs. In the example above, a single $25k contribution in month 50 ends the oan ends in ~27yrs or 325 months exactly. Monthly savings of $125 start in month 51 and end in month 325 for a total of $34k (275 x $125). However, the total savings are $82k. The additional $48k ($82k - $34k) of savings are from compounding. |